UNIT 1
MONEY
Economic development is generally believed to be dependent on the growth of real factors such as capital accumulation, technological progress, and increase in quality and skills of labour force. This view does not adequately stress the role of money in the process of economic development.It is said that money is a mere veil and intrinsically unimportant. What matters is the real goods and productive factors which money buys. However, this extreme view about the unimportance of money as such is no longer believed. Not only is money an important factor without which modern complex economic organisation is impossible, but it is also an important factor for promoting economic development. We discuss below the importance of money in the process of economic development.
In the economy today money performs several functions. Money serves as a standard of value in which other values are measured. Money is a store of value, that is, the means in which wealth can be held. It acts as a standard for deferred payments.
However, the most important function of money which distinguishes it from other goods is that it serves as a medium of exchange. That is, money is a means of payment for goods and services. It is this use of money that distinguishes a monetary economy from a barter economy. A monetary economy is one in which goods are sold for money and money is used to buy goods.
Money Promotes Productivity and Economic Growth:
Barter system was full of difficulties of exchanging goods and services between individuals. In the absence of easy exchange of goods and services the barter system worked as an obstacle to the division of labour and specialisation among individuals which is an important factor for increasing productivity and economic growth. Further, the process of economic growth leads to the expansion of production of goods and services and consequential rise in incomes of the people.
As a result, volume of transactions in the developing economy increases. This raises the demand for money to finance the increased transactions brought about by the expanded level of economic activity. Thus, the process of economic growth would be held in check if adequate supply of money is not forthcoming to meet the requirements of increase in the level of economic activity.
Money Promotes Investment:
From the viewpoint of development another important role of money lies in making the magnitude of investment independent of the current level of savings. In a barter system, the goods not consumed constitute the savings as well as investment. That is, investment is not different from current savings. The greater the current savings, the greater the investment. However, in a modern economy, this is not so. Whereas it is households which save in the form of money, it is the firms which invest money in capital goods.
Therefore, investment can differ from saving because investment activity is separated from the act of saving. More importantly, investment in a monetary economy can exceed the current level of savings. This excess of investment over savings is possible because new money can be created by the Government in the form of currency or by banks in the form of bank deposits. And this is what is important for the purpose of economic development.
In the developed countries in times of depression when idle productive capacity exists, the increase in investment made possible by creation of new money by the Government or banks would lead to the increase in aggregate demand for goods and services. In such times the supply of goods and services is elastic due to the existence of excess capacity. Therefore, increase in aggregate demand generated by the investment financed by created money brings about expansion in output of goods and services and thereby causes an increase in the level of employment.
In developing countries, the created money can play a useful role in promoting economic development. Rapid economic development can be achieved by stepping up the rate of investment or capital formation. But additional resources are required to increase the rate of investment. But in a country where a majority of the people are living at the bare subsistence level, voluntary savings, taxation.
Government borrowing cannot by themselves provide sufficient investible resources for development. The government therefore attempts to increase the volume of investible resources beyond what is possible on the basis of current level of savings through creating new money. The newly created money can be spent on investment projects both in the industrial and agricultural fields which would lead to the increase in output, income and employment.
Money and Investment in Quick-Yielding Projects:
It is widely believed that any increase in the supply of money in developing countries would lead to the rise in prices or to the emergence of inflationary pressures. However, this is not always true. A reasonable amount of newly created money helps the development of the economy by raising the level of investment. In the developing economies a lot of natural and human resources lie un-utilised and underutilized which can be employed for productive purposes.
If the newly created money is used for investment in those projects such as small irrigation works, land reclamation schemes, flood control and anti-soil erosion measures, cottage industries which yield quick returns, then the danger of inflation will not be there. These quick- yielding projects will increase the production of essential consumer goods in the short run and will therefore prevent the rise in prices.
Further, if development strategy is such that a higher priority is assigned to agriculture and other wage goods industries and further that organisational and institutional reforms are undertaken to provide all farmers with irrigation facilities, fertilizers and high- yielding varieties, agricultural output can be raised in the short period. In this framework, new money can be created to increase the level of investment without much adverse effect on prices.
Monetization and Economic Growth:
Further, as is well known, most underdeveloped countries have a large non-monetised (i.e. barter) sector where production is for the purpose of subsistence only. To break the subsistence nature of economic activity and thus generate new forces for economic growth, its monetisation is required. The introduction of money helps in bringing it in contact with the modern sector. This contact of the subsistence sector with the modern sector will lead to the expansion of its output.
In order to obtain the products of the modern industrial sector, the people engaged in the subsistence sector will make efforts to raise their output. Thus, a surplus of output over their self-consumption will be generated in this way which will ultimately break their subsistence nature.
It is supported by the past history of the developing countries. During the colonial period, the monetisation of the peasant sector led to the expansion in exports in exchange for the imported industrial products. This stepped up their agricultural development to a good extent.
Similar to the growth of production for exports the introduction of money in the subsistence agricultural sector and its contact with the modern sector, would lead to the increase in marketable surplus of foodgrains and other agricultural products which is an important factor in economic development.
If some rise in agricultural prices occurs as a result of increase in investment financed by the created money, as is likely the case, it would serve as an incentive to produce more foodgrains and supply it the market. The rise in agricultural incomes will increase demand for industrial products and would therefore accelerate their growth.
Further, the monetisation of the subsistence sector will also help in raising the volume of savings. Monetisation will bring this sector in contact with the financial institutions such as commercial and cooperative banks and insurance companies.The opportunities of earning more income through interest on saving will raise the propensity to save of the people in the present-day subsistence sector. If proper monetary policies are pursued, then instead of consuming or hoarding all their therefore incomes, these people can deposit a part of them in the financial intermediaries.
Cambridge Equations
The Cambridge version of quantity theory of money was first developed by Alfred Marshall and later modified by A.C Pigou and D.H Robertson. Since all these economists were from the Cambridge University, their version of the quantity theory came to be known as the Cambridge Version. This version is an improvement over the classical cash transactions approach. The cash balance approach provided the basis for Keynes to develop his famous Liquidity Preference Theory of Money.
According to the Cambridge version, people demand to hold money not only for transactions but also because money’s function as a ‘store of value’. Therefore, real demand for money is for transaction as well as other purposes. When money is held or hoarded, it has utility as it acquires wealth value. The amount of cash balances held by people is determined by their real value, or the purchasing power of the balances held. People will want to hold money not for the money’s sake but for the command that money has over real resources and goods.
Taken together, the community’s total demand for cash balances constitutes a certain proportion of the country’s real national income. This proportion is represented by the letter k’ in the Cambridge equation. It represents a proportion of the total real income (output produced) that people of the country demand to hold in the form of cash balances.
If we assume that in an economy, the volume of transactions are given over a period of time, the community’s total demand for real cash balances may be represented by a certain proportion (k) of the annual real national income (Y).
The proportion k, known as ‘Cambridge k’ is determined by individuals and groups of individuals on the basis of several factors like spending pattern, price level, rate of interest, general economic condition, the opportunity cost of holding cash. When people want to hold more cash, they spend less on goods and services. This lowers the demand for goods and services and price level falls. Similarly, if people want to hold less cash and spend more on transacting in goods and services, the price level will rise. Price level falls. Similarly, if people want to hold less cash and spend more on transacting in goods and services, the price level will rise. Price level determines the value of money. Higher the price level, lower will be the purchasing power of one unit on money, and vice versa.
The Cambridge version is represented by the following equation:
Md = kPY
Where,
Md = community’s demand for money
Y = real national output
P = average price (general price level)
k = proportion of national output or income that people want to hold
Let assume that money supply Ms is determined by monetary authorities
Ms = M
At full employment equilibrium, supply of money is equal to demand for money.
Ms = Md
Or
M = kPY
P = M/kY
Where,
K and y are independent of money supply
K is constant and is given by transactions demand for money
Y is constant at full employment
P and money supply M are directly proportional. If money supply is doubled, so will P and if money supply is halved, P will also be halved.
Prices are measures of the amount of money that one has to give up to obtain units of goods and services. When this macro measurement is extended to the entire economy, we get the concept of general price level.
The price level measures the amount of money that has to be given up to obtain a unit of the average good in the economy, or to obtain one unit of the total output.
The inverse or reciprocal of the price level represents value of money, or what a unit of money can buy. This is referred to as the real value of money or its purchasing power.Study of the factors that determine the price level and thus, the value of money, is one of the important subject matter of macro economics.
Different views on what determines the price have been put forward by different economist. Though they may differ in their approaches, most have concluded that the price level is determined by the supply of money and demand for money. The demand- supply analysis of price level determination at macro- level is essentially different from the demand- supply analysis of price determination at the micro-level for an individual good. Goods produced are flows while money can be both stock and flow.
The quantity theory of money was used by economists to explain changes in general price level. They believed that the quantity of money in the economy was the prime factor determining price level. Any change in the quantity of money would bring about a change in the general level. The theory is based directly on the changes brought about by an increase in the money supply. The quantity theory of money states that the value of money is based on the amount of money in the economy.
According to A.C. Pigou (Cambridge University), inflation comes in existence “when money income is expanding more than in proportion to income activity”. An increase in general price level takes place when people have more money income to spend against less goods and services.
G. Crowther (British economists)brings out the meaning precisely when he says, “inflation is a state in which the value of money is falling i.e. prices rising”.
Inflation, according to Harry G. Johnson (Canadian economist), “is a sustained rise in prices”.
Paul Samuelson (American economist) defines inflation as “a rise in the general level of prices”.
According to Milton Friedman (American economists), ‘inflation is taxation without representation’.
Causes of Inflation
Demand- Pull Inflation
- Increase in Money Supply: When the monetary authorities increase the money supply in excess of the supply of goods and services it results in additional demand and consequent increase in price level. As Milton Friedman put it “inflation is always and everywhere a monetary phenomenon”.
- Deficit Finance: As increase in money supply also takes place when the government resorts to deficit financing to incur the public expenditure. Deficit financing undertaken for unproductive investment or expenditure becomes purely inflationary. Even when it is used on productive activities, prices would still increase during the gestation period.
- Credit Creation: Commercial banks increase the quantity of money in circulation when they advance loans through credit creation. Credit creation is similar to that of deficit financing in its effects.
- Exports: Exports reduce the goods available in domestic market. Export earnings enhance the purchasing power of the exporters and others linked with export. An increase in exports would aggravate the situation by reducing the supply of goods and at the same time pushing up the demand because of additional income.
- Repayment of Public Debt: Public debt is a common feature of modern governments. When such debts are repaid, people will have more income at their disposal. Additional disposable income tends to raise the demand for goods and services.
- Black Money: Social and economic evils like corruption, tax evasion, smuggling and other illegal activities give rise to unaccounted (for tax payment) or black money. People with black money indulge in extravanza, affecting demand and thus the price level.
- Increase in Population: The size of the population is one of the important determinants of demand In many developing countries population is large in size and still increasing. India provides an example where demand outstrips supply due to the large and increasing population.
Cost- Push Inflation
Inflation need not necessarily be due to an increase in demand but increase in cost. Increase in the prices of inputs including labour, increase in profit margin by the business firms and monopsony in factor market may push up prices as they influence the supply price.
The important cost push factors are:
- Increase in wages: When prices increase due to increase in wages it is called wage-push inflation. Wages are influenced by many factors besides the demand and supply forces. Trade unions play an important role in deciding the wage rate. Strong and powerful trade unions succeed in securing higher wages for their members. Higher wages granted in the organised sector influencing the wage rate in the unorganised sector too, resulting in an increase in cost everywhere.
- Increase in Material cost: Prices of materials used in producing goods constitute a significant part of the cost. Prices of the materials may increase either due to an increase in demand for these materials or independently owing to national and international developments. Increase in crude oil price till recently is an example in this context. When the prices of basis inputs like energy, cement, steel, etc. increase, the effect is felt throughout the economy. An increase in the prices of materials especially the basic inputs alters the cost structure of all goods and services. Higher the cost of production leads to upward revision of final prices.
- Increase in Profit Margin: Firms operating under oligopoly or enjoying monopoly power (petroleum firms in public sector) may have ‘administered prices’ with higher profit margins. Such administered prices though imposed by few firms, have their impact on other firms too. The desire to have higher profit margins by all those who have the power to do so becomes the cause for inflationary trend.
- Other factors: Cost of production may increase when input prices go up due to scarcity – natural or artificial. Natural calamities like draught or floods adversely affect supplies of raw materials thus making them dearer. Firms operating with excess capacity either because of monopolistic competitive market or any other reasons, produce at a higher cost.
Inflation must be cotrolled at an appropriate level. Uncontrolled inflation may turn into hyper inflation. Since inflation occurs due to disequilibrium in aggregate demand and aggregate supply, it would be controlled by correcting the forces which causes such disequilibrium. Control of inflation requires a combination of monetary, fiscal and other measures.
Monetary Measures
An increase in money supply without the corresponding increase in supply of goods and services creates excess demand causing inflation. Monetary and services creates excess demand causing inflation Monetary authorities through monetary instruments could increase the cost of credit and reduce the money supply. At the same time monetary measures may encourage the production and supply of essential commodities by supplying the requires amount of credit at concessional terms. For this purpose the central bank of the country applies quantitative and qualitative methods.
The Quantitative Methods Are:
Bank Rate: Inflation compels the Central Bank of the economy to increase the Bank Rate. Bank rate is the rate at which the central bank lends money to the member banks. An increase in bank rate makes borrowing costlier thus discourages borrowing, leading to a check on increase in supply. Similarly lowering bank rate makes borrowing cheaper, increases money supply along with decrease in cost. Cost push inflation may require to bring down the cost of borrowing. A change in bank rate brings changes in other interest rates in market in the same direction.
Open Market Operation (OMO): Under this method a central bank sells or purchases government securities in the market. Any body can participate in this purchase or sale, hence it is called open market operation. The central bank reduces quantity of money in circulation through the sale of securities and increases the quantity of money by purchasing them. During inflation it is expected to sell the securities, bringing down the money in circulation, hence the aggregate demand in the economy for goods and services.
Variable Reserve Ratio (VRR): Variable reserve ratio has two components: (i) Cash reserve ratio (CRR) and Statutory Liquidity Ratio (SLR). An increase in these ratios, reduces the ability to create credit. A reduction in CRR and SLR increases the reserves with banks and consequently their ability to expand credit. During inflation these ratios are usually increased. In recent decades many central banks have introduced some additional quantitive measures. They are in the form of repo rate and liquidity adjustment facility (LAF). They influence the cost of borrowing (higher cost during inflation) affecting total money in circulation.
The above mentioned quantitative methods may not be very effective in controlling inflation. Increase in prices which bring more profits and prevailing optimism will not deter business firms from borrowing at a higher costs.
An uniform monetary policy- dear or cheap- throughout the economy does not bring the required result. The central banks, therefore, apply the selective credit control measures too. These measures comprise margin requirements, consumer credit controls, directives, rationing of credit and any other method whereby a selective approach can be adopted in supplying credit. Selective credit controls discriminate in favour of essential activities and discourage demand for credit for non-essential uses. In developing countries selective credit controls are more popular as they help the monetary authorities to have a ‘controlled – expansion’ of credit. Quantitative measures in these countries are less effective due to the underdevelopment of the money market. Monetary measures by themselves are not enough to control inflation. They become more helpless if inflation is due to cost- push.
In extreme cases the central bank/ government, may resort to demonetisation of currency. This measure is usually applied to higher denomination currency. It helps to bring out black money and check excess demand. Hypher inflation may even compel the government to issue new currency and replace the existing one in a given ratio, for example 100: 1. India demonetised its higher value currencies on 8 November 2016, to flush out black money and check the price level.
Fiscal Measures
Inflation cannot be controlled by monetary measures alone. They should be supported by fiscal measures. Broadly speaking, the government manipulates the budget to reduce the private as well as the public expenditure to check demand for goods and services and encourage production of essential commodities through incentives to private sector in addition to its own expenditure on production and distribution of goods ad services.
The fiscal measures are (i) taxation (ii) public borrowing (iii) compulsory saving and (iv) public expenditure.
Direct and Indirect taxes are leived to reduce the disposable income of the people. While imposing the tax, care should be taken to avoid the adverse effects of taxation on savings, investment and production. Essential commodities should not be taxed, lest inflation be aggrevated.
Public borrowing can be undertaken to reduce the disposable income of the people. It is to reduce the quantity of money with the public. It is a costly instrument since the government has to pay interest on public loans. Repayment of public loans during inflation should be avoided. This would prevent additional money supply and consequent additional demand.
Compulsory saving or any other forced saving scheme and deferred payment (a part of the payment is credited to the employees provident fund accounts, thus blocking its current use) are some other instruments to reduce excess demand.
Public expenditure is the major source of injecting money into the economy. Modern welfare states spend huge amounts of money through public projects and welfare schemes. Public expenditure should be reduced during inflation. Though it is difficultto cut down public expenditure the government should attempt to avoid all unproductive expenditure.
Direct (Administrative) Measures
Some of the direct measures are:
Price control or ceiling on price specially of essential commodities.
Public distribution system (PDS) to supply or distribute essential consumer goods. Rationing and fair price shops are the channels through which the pubic distribution system is operated.
Imports of essential consumer commodities may be required to maintain the supply.
Control or freezing of wages, profits, dividends and bonus may also be introduced. Such controls aim at limiting the income of the people and thereby reducing the demand for goods and services. These measures being drastic are likely to create social and political tension.
Increase in supply: If inflation is due to shortage of goods and services, controlling demand through monetary and fiscal measures is not of much use. Here the solution lies in increasing the supply of goods and services by improving the working of supply chains. The long-run solution lies in increasing production by creating a positive and conducive environment. This may involve improving infrastructure, providing incentives and effective implementation of various measures which enable more production.
Indexation: Inflation affects all sections of people. Among the different sections, wage/ salary earners and other fixed income group suffer the most. To compensate against inflation, a method of indexation of their income can be introduced. Indexation, according to Samuelson and Nordhaus, “is a mechanism of wages, prices and contracts that are partially or wholly compensated for changes in the general price level”. Under this system, payment received by the above mentioned groups can be increased to the extent of rate of inflation, so that their real income remains the same. In India the practice of periodical increase in dearness allowance is one of the methods of compensation against inflation.
Control of inflation is a must and should be attempted before it crosses a moderate limit. Attempts to control inflation by any particular types of measures are bound to fail. A judicious combination of all methods is a must to achieve success. A dear monetary policy must be supported by a surplus budgetary (or reduced deficit) policy along with necessary direct measures.
Success of the measures to control inflation depends on effective implementation which requires efficient and honest administration.
Definition: An inflationary gap, also known as an expansionary gap, is the difference between the real GDP and the full-employment real GDP. In fact, the real GDP outweighs the full employment real GDP because an increase in the real GDP causes the general price level to rise in the long-term.
What Does Inflationary Gap Mean?
An inflationary gap is always related to a business-cycle expansion and arises when the equilibrium level of an economy’s aggregate output is greater than the output that could be produced at full employment.
For instance, the economy’s total output is $6 trillion and the full-employment real GDP is $4 trillion, the inflationary gap is $2 trillion, which means that the aggregate output has to decrease by $2 trillion to eliminate the inflationary gap. To fight this gap, governments impose a contractionary fiscal policy that increases taxation and decreases government spending to lower disposable income and consumption, thus lowering the aggregate demand and the general price level.
Let’s look at an example.
Example
Saudi Arabia employs all its available resources and produces 11.6 barrels of oil per day. The aggregate demand for oil is estimated at 5 barrels of oil per day because there is a growing uncertainty over oil supplies, regional conflict and price hikes, which lower consumer confidence. In this case, since the aggregate demand (real GDP) is lower than the full-employment real GDP, there is no inflationary gap.
Conversely, if the aggregate demand for oil was 13.2 barrels of day, and consumer confidence was high, there would be an inflationary gap of 1.6 barrels of oil per day because the aggregate demand (real GDP) would be higher than the full-employment real GDP.
Meaning:
Monetary policy is concerned with the changes in the supply of money and credit. It refers to the policy measures undertaken by the central bank to influence the availability, cost and use of money and credit with the help of monetary techniques to achieve specific objectives. Monetary policy aims at influencing economic activity in the economy mainly through two major variables, i.e, (a) money or credit supply and (b) the rate of interest.
Definition:
RBI: Monetary policy refers to the policy of the central bank with regard to the use of monetary instruments under its control to achieve the goals specified in the Act (1934).
A.J. Shapiro: “Monetary policy is the exercise of the central bank’s control over the money supply as an instrument for achieving the objectives of economic policy.”
N.G. Mankiw: “Monetary policy refers to the setting of the money supply in the economy by the central bank.”
G.F. Stanlake: “It is any deliberate action by the monetary authorities which is designed to change the availability(money supply) or the cost of money (rate of interest).”
Objectives:
Monetary policy is not an end in itself, but a means to an end. It involves the management of money and credit for the betterment of the general economic policy of the government to achieve predetermined objectives. The objectives of monetary policy vary in different countries at different times and under different economic conditions.
Various objectives or goals of monetary policy are:
- Price stability( low and stable rate of inflation) – Stable prices improve public confidence, promote business activity, and ensure equal distribution of income and wealth. It is a pre-requisite for development. The stability objective includes maintaining the domestic as well as the external value of the currency.
- Economic growth – One of the most important OBJECTIVE OF MONETARY POLICY has been the rapid economic growth and development of a country. A suitable monetary policy would help with the proper utilisation of natural and human resources, more capital formation, more employment, increase in national and per capita income along with an increase in the standard of living.
- Balance of payments (BOP) Equlibrium: Many developing countries suffer from disequilibrium in BOP can be ‘BOP surplus’ or ‘BOP deficit’. The former reflects an excess money supply in domestic economy, while the later stands for stringency of money. If the monetary policy succeeds in maintaining monetary equilibrium can be attained.
- Exchange stability (orderly foreign exchange market and an adequate level of foreign exchange reserves): Exchange rate is the price of a home currency expressed in terms of any foreign currency. The traditional objective of monetary policy has been the achievement of stable exchange rates. If the exchange rates is very volatile (frequent ups and down), it leads to the international community losing confidence in the economy. Monetary policy aims at maintaining relative stability in the exchange rate.
- Full employment: Full employment has been ranked among the foremost objectives of monetary policy. It is an important goal not only because unemployment leads to wastage of potential output, but also because of the loss of social standing and self-respect.
- Reduction in Equality and Wealth: Inequality in income and wealth due to right of private property and law of inheritance is a common feature of capitalist and mixed economies. As a result, society is divided into two classes, rich and poor The objective of monetary policy is to reduce the inequalities of income and wealth.
- Creation and Expansion of Financial Institutions: A major objective of monetary policy in a developing country is to speed up the process of economic development by providing credit facilities and mobilising savings for productive purposes. The monetary authority can help in establishment and expansion of banks and institutions in urban and rural areas.
