Unit 2
Changes in the Value of Money and its Measurements
Q1) What is Inflation?
A1) Inflation refers to the broad increase in prices across a sector or an industry, like the automotive or energy business—and ultimately a country’s entire economy. The chief measures of U.S. Inflation are the Consumer Price Index (CPI), the Producer Price Index (PPI) and the Personal Consumption Expenditures Price Index (PCE), all of which use varying measures to track the change in prices consumers pay and producers receive in industries across the whole American economy.
Inflation occurs when prices rise, decreasing the purchasing power of your dollars. In 1980, for example, a movie ticket cost on average $2.89. By 2019, the average price of a movie ticket had risen to $9.16. If you saved a $10 bill from 1980, it would buy two fewer movie tickets in 2019 than it would have nearly four decades earlier.
Though it can be frustrating to think about your dollars losing value, most economists consider a small amount of inflation a sign of a healthy economy. A moderate inflation rate encourages you to spend or invest your money today, rather than stuff it under your mattress and watch its value diminish.
Q2) What is Deflation?
A2) When the overall price level decreases so that inflation rate becomes negative, it is called deflation. It is the opposite of the often-encountered inflation.
During times of deflation, since the money supply is tightened, there is an increase in the value of money, which increases the real value of debt. Since money is valued more highly during deflationary periods, borrowers are actually paying more because the debt payments remain unchanged.
Deflation is a scenario where there are falling prices of goods and services across the economy. Although the ability to purchase goods and services at a discount may sound like an ideal situation, it has the potential to cause a lot of problems throughout the economy. Some of the negative side effects of deflation are a decrease in consumer spending, increased interest rates, and an increase in the real value of debt.
Real Value of Debt
All of these problems can increase the real value of debt. During times of deflation, since the money supply is tightened, there is an increase in the value of money, which increases the real value of debt. Most debt payments, such as mortgages, are fixed, and when prices fall during deflation, the cost of debt remains at the old level. In other words, in real terms–which factors in price changes–the debt levels have increased.
As a result, it can become harder for borrowers to pay their debts. Since money is valued more highly during deflationary periods, borrowers are actually paying more because the debt payments remain unchanged.
Example of Deflation's Impact on the National Debt
Let's say as an example, the government of Greece owed $100 billion to the United States in the previous year. Thinking in terms of oil, the government could have bought 100 million barrels of oil. However, this year, Greece is experiencing a deflationary period and could buy 200 million barrels of oil with the same amount, since the prices of goods and services have decreased. However, its debt has stayed the same, but now the country is actually paying more–200 million barrels of oil as opposed to 100 million. In other words, after deflation, Greece would be paying the U.S. 200 million barrels of oil worth of money to pay their debt. As a result, deflation can cause the real value of national debt to rise.
Q3) What are the best investments for deflationary period?
A3) For many, deflationary periods are marked by conservation and even survival. But for some, they're able to maintain their investments and continue without a significant decrease in their lifestyle.
Deflation may sound like a great time for investors because prices are falling. But the problem is that prices can keep falling. There's no way to know for sure when the bottom has been reached.
Rather than chasing prices lower, it may be better to look at investments that maintain their value or at least don't drop as fast. Below are three examples of investments that tend to remain durable during deflationary periods.
1. Investment-Grade Bonds
Investment-grade bonds include Treasuries and those of high-quality, blue-chip companies. These types of bonds work well during a deflationary environment because of the quality of the entity behind them.
The government isn’t going broke, which means investors can have confidence that they’ll continue to receive regular payments and eventually their principal.
It’s the same with high-quality companies. These companies have been around for a long time, have great management and solid balance sheets. Their products are in demand. It’s unlikely these companies will go out of business, even during a recession.
2. Defensive Stocks
Defensive stocks are those of companies that sell products or services that we people can't easily cut out of their lives. Consumer goods and utilities are two of the most common examples.
Think of toilet paper, food, and electricity. No matter what the economic conditions are, people will always need these goods and services.
If you don't want to invest in individual stocks, you could invest in ETFs that track the Dow Jones U.S. Consumer Goods Index or the Dow Jones U.S. Utilities Index.
For consumer goods, popular ETFs include iShares US Consumer Goods (IYK) and ProShares Ultra Consumer Goods (UGE). And ETF options for utilities include iShares US Utilities (IDU) and ProShares Ultra Utilities (UPW).
3. Dividend-Paying Stocks
Dividend-paying stocks remain in demand during a recession because of their income. While the stock price may decline, investors can count on the dividends to continue providing steady passive income.
Investors should focus on high-quality dividend-paying companies, rather than simply seeking companies that have high dividend yields. An abnormally-high dividend yield may actually be a warning sign because it could indicate that the stock's price has recently taken a nosedive.
If you're looking for strong, dividend-paying companies, the "Dividend Aristocrats" can be a great place to start. Dividend aristocrats are companies that have increased their dividends for at least 25 consecutive years. As of September 2021, there are 63 companies that meet these requirements.
Q4) Explain Quantity theory of money.
A4) Monetary economics is a branch of economics that studies different theories of money. One of the primary research areas for this branch of economics is the quantity theory of money (QTM). According to the quantity theory of money, the general price level of goods and services is proportional to the money supply in an economy. While this theory was originally formulated by Polish mathematician Nicolaus Copernicus in 1517, it was popularized later by economists Milton Friedman and Anna Schwartz after the publication of their book, "A Monetary History of the United States, 1867-1960," in 1963.1
According to the quantity theory of money, if the amount of money in an economy double, all else equal, price levels will also double. This means that the consumer will pay twice as much for the same amount of goods and services. This increase in price levels will eventually result in a rising inflation level; inflation is a measure of the rate of rising prices of goods and services in an economy.
The same forces that influence the supply and demand of any commodity also influence the supply and demand of money: an increase in the supply of money decreases the marginal value of money–in other words, when the money supply increases, but with all else being equal or ceteris paribus, the buying capacity of one unit of currency decreases. As a way of adjusting for this decrease in money's marginal value, the prices of goods and services rises; this results in a higher inflation level.
The Quantity Theory of Money refers to the idea that the quantity of money available (money supply) grows at the same rate as price levels do in the long run. When interest rates fall or taxes decrease and the access to money becomes less restricted, consumers become less sensitive to price changes and, thus, will have a higher propensity to consume. As a result, the aggregate demand curve will shift right, thus shifting up the equilibrium price level.
Exchange Equation
To better understand the Quantity Theory of Money, we can use the Exchange Equation. The equation enables economists to model the relationship between money supply and price levels. The exchange equation is:
M.V = P.Q
Where:
M – refers to the money supply
V – refers to the Velocity of Money, which measures how much a single dollar of money supply spend contributes to GDP
P – refers to the prevailing price level
Q – refers to the quantity of goods and services produced in the economy
Holding Q and V constant, we can see that increases in the money supply will cause price levels to increase, thus causing inflation. The assumption that Q and V are constant holds in the long run as these factors cannot be influenced by changes in the economy’s money supply.
The theory provides a quick overview of monetarist theory, which states that changes in the current money supply cause fluctuations in overall economic output; excessive growth in money supply causes hikes in inflation.
Q5) What is an Index number?
A5) An index number is a statistical derive to measure changes in the value of money. It is a number which represents the average price of a group of commodities at a particular time in relation to the average price of the same group of commodities at another time.
Professor Chandler defines it thus – “An index number of prices is a figure showing the height of average prices at one time relative to their height at some other time that is taken at the base period.”
Q6) What are the methods of Construction of Index Number?
A6) In constructing an index number, the following steps should be noted:
1. Purpose of the Index Number: Before constructing an index number, it should be decided the purpose for which it is needed. An index number constructed for one category or purpose cannot be used for others. A cost-of-living index of working classes cannot be used for farmers because the items entering into their consumption will be different.
2. Selection of Commodities:
Commodities to be selected depend upon the purpose or objective of the index number to be constructed. But the number of commodities should neither be too large nor too small. Moreover, commodities to be selected must be broadly representative of the group of commodities. They should also be comparable in the sense that standard or graded items should be taken.
3. Selection of Prices:
The next step is to select the prices of these commodities. For this purpose, care should be taken to select prices from representative persons, places or journals or other sources. But they must be reliable. Prices may be quoted in money terms i.e., Rs. 100 per quantal or in quantity terms, i.e., 2 kg per rupee.
Care should be taken not to mix these prices. Then the problem is to select wholesale or retail prices. This depends on the type of index number. For a consumer price index, wholesale prices are required, for a cost-of-living index, retail prices are needed. But different prices should not be mixed up.
4. Selection of an Average:
Since index numbers are averages, the problem is how to select an appropriate average. The two important averages are the arithmetic mean and geometric mean. The arithmetic mean is the simpler of the two. But geometric mean is more accurate. However, the average prices should be reduced to price relatives (percentages) either on the basis of the fixed base method or the chain base method.
5. Selection of Weights:
While constructing an index number due weightage or importance should be given to the various commodities. Commodities which are more important in the consumption of consumers should be given higher weightage than other commodities. The weights are determined with reference to the relative amounts of income spent on commodities by consumers. Weights may be given in terms of value or quantity.
6. Selection of the Base Period:
The selection of the base period is the most important step in the construction of an index number. It is a period against which comparisons are made. The base period should be normal and free from any unusual events such as war, famine, earthquake, drought, boom, etc. It should not be either very recent or remote.
7. Selection of Formula:
A number of formulas have been devised to construct an index number. But the selection of an appropriate formula depends upon the availability of data and purpose of the index number. No single formula may be used for all types of index numbers.
Q7) What is Monetary policy?
A7) Monetary policy is a set of tools that a nation's central bank has available to promote sustainable economic growth by controlling the overall supply of money that is available to the nation's banks, its consumers, and its businesses.
The goal is to keep the economy humming along at a rate that is neither too hot nor too cold. The central bank may force up interest rates on borrowing in order to discourage spending or force down interest rates to inspire more borrowing and spending.
The main weapon at its disposal is the nation's money. The central bank sets the rates it charges to loan money to the nation's banks. When it raises or lowers its rates, all financial institutions tweak the rates they charge all of their customers, from big businesses borrowing for major projects to home buyers applying for mortgages.
All of those customers are rate-sensitive. They're more likely to borrow when rates are low and put off borrowing when rates are high.
Q8) Explain the tools of monetary policy.
A8) Central banks use various tools to implement monetary policies. The widely utilized policy tools include:
1. Interest rate adjustment
A central bank can influence interest rates by changing the discount rate. The discount rate (base rate) is an interest rate charged by a central bank to banks for short-term loans. For example, if a central bank increases the discount rate, the cost of borrowing for the banks increases. Subsequently, the banks will increase the interest rate they charge their customers. Thus, the cost of borrowing in the economy will increase, and the money supply will decrease.
2. Change reserve requirements
Central banks usually set up the minimum number of reserves that must be held by a commercial bank. By changing the required amount, the central bank can influence the money supply in the economy. If monetary authorities increase the required reserve amount, commercial banks find less money available to lend to their clients and thus, money supply decreases.
Commercial banks can’t use the reserves to make loans or fund investments into new businesses. Since it constitutes a lost opportunity for the commercial banks, central banks pay them interest on the reserves. The interest is known as IOR or IORR (interest on reserves or interest on required reserves).
3. Open market operations
The central bank can either purchase or sell securities issued by the government to affect the money supply. For example, central banks can purchase government bonds. As a result, banks will obtain more money to increase the lending and money supply in the economy.
Q9) What is Indian Money Market?
A9) Money Market is a segment of the financial market in India where borrowing and lending of short-term funds take place. The maturity of money market instruments is from one day to one year. In India, this market is regulated by both RBI (the Reserve bank of India) and SEBI (the Security and Exchange Board of India). The nature of transactions in this market is such that they are large in amount and high in volume. Thus, we can say that the entire market is dominated by a small number of large players.
Q10) Explain the structure of organized money market of India.
A10) The organized money market in India is not a single market. It is a combination of markets of various instruments. The following are the instruments that are integral parts of the Indian money market system.
1. Call money or notice money
Call money, notice money, and term money markets are sub-markets of the Indian money market. These markets provide funds for very short-term. Lending and borrowing from the call money market for 1 day.
Whereas lending and borrowing of funds from notice money market are for 2 to 14 days. And when there are borrowing and lending of funds for the tenor of more than 14 days, it refers to “Term Money”.
2. Treasury bills
The Bill market is a sub-market of this market in India. There are two types of the bill in the money market. They are treasury bills and commercial bill. The treasury bills are also known as T-Bills, T-bills are issued by the Central bank on behalf of Government, whereas Commercial Bills are issued by Financial Institutions.
Treasury bills do not yield any interest, but it is issued at discount and repaid at par at the time of maturity. In T-bills there is no risk of default; it is a safe investment instrument.
3. Commercial bills
Commercial bill is a money market instrument which is similar to the bill of exchange; it is issued by a Commercial organization to raise money for short-term needs. In India, the participants of the commercial bill market are banks and financial institutions.
4.Certificate of deposits
Certificate of Deposits also known as CDs. It is a negotiable money market instrument. It is like a promissory note. Rates, terms, and amounts vary from institution to institution. CDs are not supposed to trade publicly neither it is traded on any exchange.
In general institutions issue certificate of deposit at discount on its face value. The banks and financial institutions can issue CDs on a floating rate basis.
5. Commercial paper
The commercial paper is another money market instrument in India. We also call commercial paper as CP. CP refers to a short-term unsecured money market instrument. Big corporations with good credit rating issue commercial paper as a promissory note. There is no collateral support for CPs. Hence, only large firms with considerable financial strength can issue the instrument.
6. Money market mutual funds (MMMFs)
The money-market mutual funds were introduced by RBI in 1992 and since 2000 they are brought under the regulation of SEBI. It is an open-ended mutual fund which invests in short-term debt securities. This kind of mutual fund solely invests in instruments of the money market.
7. Repo and the reverse repo market
Repo means “Repurchase Agreement”. It exists in India since December 1992. REPO means selling a security under an agreement to repurchase it at a predetermined date and rate. Those who deal in government securities they use the repo as an overnight borrowing.
Q11) How Inflation can become a destructive force in an economy?
A11) Inflation can become a destructive force in an economy, however, when it is allowed to get out of hand and rise dramatically. Unchecked inflation can topple a country’s economy, like in 2018 when Venezuela’s inflation rate hit over 1,000,000% a month, causing the economy to collapse and forcing countless citizens to flee the country.
The impact inflation has on the time value of money is that it decreases the value of a dollar over time. The time value of money is a concept that describes how the money available to you today is worth more than the same amount of money at a future date.
This also assumes you do not invest the money available to you today in an equity security, a debt instrument, or an interest-bearing bank account. Essentially, if you have a dollar in your pocket today, that dollars’ worth, or value, will be lower one year from today if you keep it in your pocket.
Inflation increases the price of goods and services over time, effectively decreasing the number of goods and services you can buy with a dollar in the future as opposed to a dollar today. If wages remain the same but inflation causes the prices of goods and services to increase over time, it will take a larger percentage of your income to purchase the same good or service in the future.
Q12) How deflation works?
A12) When deflation is occurring, consumers often slow their spending since they expect prices to fall further. Businesses too, delay spending, which can lead to a slowdown in economic growth since consumer and business spending are two key drivers for growth.
Deflation tightens the money supply because there's an increase in real interest rates, causing consumers to save money. It hinders the revenue growth of firms, potentially causing lower wages and layoffs for workers. This cycle leads to higher unemployment rates and lower growth rates.
Deflation is the opposite of inflation, which represents widespread price increases of goods and services in an economy.
Q13) Give example of Deflation's Impact on the National Debt.
A13) Let's say as an example, the government of Greece owed $100 billion to the United States in the previous year. Thinking in terms of oil, the government could have bought 100 million barrels of oil. However, this year, Greece is experiencing a deflationary period and could buy 200 million barrels of oil with the same amount, since the prices of goods and services have decreased. However, its debt has stayed the same, but now the country is actually paying more–200 million barrels of oil as opposed to 100 million. In other words, after deflation, Greece would be paying the U.S. 200 million barrels of oil worth of money to pay their debt. As a result, deflation can cause the real value of national debt to rise.
Q14) What are Defensive stocks?
A14) Defensive stocks are those of companies that sell products or services that we people can't easily cut out of their lives. Consumer goods and utilities are two of the most common examples.
Think of toilet paper, food, and electricity. No matter what the economic conditions are, people will always need these goods and services.
If you don't want to invest in individual stocks, you could invest in ETFs that track the Dow Jones U.S. Consumer Goods Index or the Dow Jones U.S. Utilities Index.
For consumer goods, popular ETFs include iShares US Consumer Goods (IYK) and ProShares Ultra Consumer Goods (UGE). And ETF options for utilities include iShares US Utilities (IDU) and ProShares Ultra Utilities (UPW).
Q15) What are Dividend paying stocks?
A15) Dividend-paying stocks remain in demand during a recession because of their income. While the stock price may decline, investors can count on the dividends to continue providing steady passive income.
Investors should focus on high-quality dividend-paying companies, rather than simply seeking companies that have high dividend yields. An abnormally-high dividend yield may actually be a warning sign because it could indicate that the stock's price has recently taken a nosedive.
If you're looking for strong, dividend-paying companies, the "Dividend Aristocrats" can be a great place to start. Dividend aristocrats are companies that have increased their dividends for at least 25 consecutive years. As of September 2021, there are 63 companies that meet these requirements.
Q16) What are Investment grade bonds?
A16) Investment-grade bonds include Treasuries and those of high-quality, blue-chip companies. These types of bonds work well during a deflationary environment because of the quality of the entity behind them.
The government isn’t going broke, which means investors can have confidence that they’ll continue to receive regular payments and eventually their principal.
It’s the same with high-quality companies. These companies have been around for a long time, have great management and solid balance sheets. Their products are in demand. It’s unlikely these companies will go out of business, even during a recession.
Q17) Give the Exchange equation to understand the Quantity Theory of Money.
A17) To better understand the Quantity Theory of Money, we can use the Exchange Equation. The equation enables economists to model the relationship between money supply and price levels. The exchange equation is:
M.V = P.Q
Where:
M – refers to the money supply
V – refers to the Velocity of Money, which measures how much a single dollar of money supply spend contributes to GDP
P – refers to the prevailing price level
Q – refers to the quantity of goods and services produced in the economy
Holding Q and V constant, we can see that increases in the money supply will cause price levels to increase, thus causing inflation. The assumption that Q and V are constant holds in the long run as these factors cannot be influenced by changes in the economy’s money supply.
The theory provides a quick overview of monetarist theory, which states that changes in the current money supply cause fluctuations in overall economic output; excessive growth in money supply causes hikes in inflation.
Q18) What are the points to be noted to understand the meaning of the term index number?
A18) First, an average figure relates to a single group of commodities. But the various items in the group are expressed in different units. For example, a consumer price index contains such diverse items as food, clothing, fuel and lighting, house rent, and miscellaneous things. Food consists of wheat, ghee, etc. expressed in kgs. Cloth is expressed in metres, and lighting in kws. An index number expresses the average of all such diverse items in different units.
Second, an index number measures the net increase or decrease of the average prices for the group under study. For instance, if the consumer price index has increased from 150 in 1982 as compared to 100 in 1980, it shows a net increase of 50 per cent in the prices of commodities included in the index.
Third, an index number measures the extent of changes in the value of money (or price level) over a period of time, given a base period. If the base period is the year 1970, we can measure change in the average price level for the preceding and succeeding years.
Q19) What are the primary objectives of monetary policies?
A19) The primary objectives of monetary policies are the management of inflation or unemployment, and maintenance of currency exchange rates.
1. Inflation
Monetary policies can target inflation levels. A low level of inflation is considered to be healthy for the economy. If inflation is high, a contractionary policy can address this issue.
2. Unemployment
Monetary policies can influence the level of unemployment in the economy. For example, an expansionary monetary policy generally decreases unemployment because the higher money supply stimulates business activities that lead to the expansion of the job market.
3. Currency exchange rates
Using its fiscal authority, a central bank can regulate the exchange rates between domestic and foreign currencies. For example, the central bank may increase the money supply by issuing more currency. In such a case, the domestic currency becomes cheaper relative to its foreign counterparts.
Q20) What are the objectives of Indian Money market?
A20) The following are the important objectives of an Indian money market –
- Facilitate a parking place to employ short-term surplus funds.
- Aid room for overcoming short-term deficits.
- To enable the Central Bank to influence and regulate liquidity in the economy through its intervention in this market.
- Help reasonable access to users of short-term funds to meet their requirements quickly, adequately and at reasonable costs.
Segments of the Indian money market
- The Indian money-market has the following two segments. The existence of the unorganized market, though illegal, yet operates. However, we that is out of the scope of the present article. So, we will concentrate exclusively on the organized money-markets in India. Wherever, in the blog article or elsewhere in the site we refer money-markets, it is in organized money-market only.
1. Unorganized money-market
- The unorganized money market is an old and ancient market, mainly it made of indigenous bankers and money lenders, etc.
2. Organized money-market
- The organized money market is that part which comes under the regulatory ambit of RBI & SEBI. Governments (Central and State), Discount and Finance House of India (DFHI), Mutual Funds, Corporate, Commercial or Cooperative Banks, Public Sector Undertakings, Insurance Companies, and Financial Institutions and Non-Banking Financial Companies (NBFCs) are the key players of the organized Indian money market.
Unit 2
Changes in the Value of Money and its Measurements
Q1) What is Inflation?
A1) Inflation refers to the broad increase in prices across a sector or an industry, like the automotive or energy business—and ultimately a country’s entire economy. The chief measures of U.S. Inflation are the Consumer Price Index (CPI), the Producer Price Index (PPI) and the Personal Consumption Expenditures Price Index (PCE), all of which use varying measures to track the change in prices consumers pay and producers receive in industries across the whole American economy.
Inflation occurs when prices rise, decreasing the purchasing power of your dollars. In 1980, for example, a movie ticket cost on average $2.89. By 2019, the average price of a movie ticket had risen to $9.16. If you saved a $10 bill from 1980, it would buy two fewer movie tickets in 2019 than it would have nearly four decades earlier.
Though it can be frustrating to think about your dollars losing value, most economists consider a small amount of inflation a sign of a healthy economy. A moderate inflation rate encourages you to spend or invest your money today, rather than stuff it under your mattress and watch its value diminish.
Q2) What is Deflation?
A2) When the overall price level decreases so that inflation rate becomes negative, it is called deflation. It is the opposite of the often-encountered inflation.
During times of deflation, since the money supply is tightened, there is an increase in the value of money, which increases the real value of debt. Since money is valued more highly during deflationary periods, borrowers are actually paying more because the debt payments remain unchanged.
Deflation is a scenario where there are falling prices of goods and services across the economy. Although the ability to purchase goods and services at a discount may sound like an ideal situation, it has the potential to cause a lot of problems throughout the economy. Some of the negative side effects of deflation are a decrease in consumer spending, increased interest rates, and an increase in the real value of debt.
Real Value of Debt
All of these problems can increase the real value of debt. During times of deflation, since the money supply is tightened, there is an increase in the value of money, which increases the real value of debt. Most debt payments, such as mortgages, are fixed, and when prices fall during deflation, the cost of debt remains at the old level. In other words, in real terms–which factors in price changes–the debt levels have increased.
As a result, it can become harder for borrowers to pay their debts. Since money is valued more highly during deflationary periods, borrowers are actually paying more because the debt payments remain unchanged.
Example of Deflation's Impact on the National Debt
Let's say as an example, the government of Greece owed $100 billion to the United States in the previous year. Thinking in terms of oil, the government could have bought 100 million barrels of oil. However, this year, Greece is experiencing a deflationary period and could buy 200 million barrels of oil with the same amount, since the prices of goods and services have decreased. However, its debt has stayed the same, but now the country is actually paying more–200 million barrels of oil as opposed to 100 million. In other words, after deflation, Greece would be paying the U.S. 200 million barrels of oil worth of money to pay their debt. As a result, deflation can cause the real value of national debt to rise.
Q3) What are the best investments for deflationary period?
A3) For many, deflationary periods are marked by conservation and even survival. But for some, they're able to maintain their investments and continue without a significant decrease in their lifestyle.
Deflation may sound like a great time for investors because prices are falling. But the problem is that prices can keep falling. There's no way to know for sure when the bottom has been reached.
Rather than chasing prices lower, it may be better to look at investments that maintain their value or at least don't drop as fast. Below are three examples of investments that tend to remain durable during deflationary periods.
1. Investment-Grade Bonds
Investment-grade bonds include Treasuries and those of high-quality, blue-chip companies. These types of bonds work well during a deflationary environment because of the quality of the entity behind them.
The government isn’t going broke, which means investors can have confidence that they’ll continue to receive regular payments and eventually their principal.
It’s the same with high-quality companies. These companies have been around for a long time, have great management and solid balance sheets. Their products are in demand. It’s unlikely these companies will go out of business, even during a recession.
2. Defensive Stocks
Defensive stocks are those of companies that sell products or services that we people can't easily cut out of their lives. Consumer goods and utilities are two of the most common examples.
Think of toilet paper, food, and electricity. No matter what the economic conditions are, people will always need these goods and services.
If you don't want to invest in individual stocks, you could invest in ETFs that track the Dow Jones U.S. Consumer Goods Index or the Dow Jones U.S. Utilities Index.
For consumer goods, popular ETFs include iShares US Consumer Goods (IYK) and ProShares Ultra Consumer Goods (UGE). And ETF options for utilities include iShares US Utilities (IDU) and ProShares Ultra Utilities (UPW).
3. Dividend-Paying Stocks
Dividend-paying stocks remain in demand during a recession because of their income. While the stock price may decline, investors can count on the dividends to continue providing steady passive income.
Investors should focus on high-quality dividend-paying companies, rather than simply seeking companies that have high dividend yields. An abnormally-high dividend yield may actually be a warning sign because it could indicate that the stock's price has recently taken a nosedive.
If you're looking for strong, dividend-paying companies, the "Dividend Aristocrats" can be a great place to start. Dividend aristocrats are companies that have increased their dividends for at least 25 consecutive years. As of September 2021, there are 63 companies that meet these requirements.
Q4) Explain Quantity theory of money.
A4) Monetary economics is a branch of economics that studies different theories of money. One of the primary research areas for this branch of economics is the quantity theory of money (QTM). According to the quantity theory of money, the general price level of goods and services is proportional to the money supply in an economy. While this theory was originally formulated by Polish mathematician Nicolaus Copernicus in 1517, it was popularized later by economists Milton Friedman and Anna Schwartz after the publication of their book, "A Monetary History of the United States, 1867-1960," in 1963.1
According to the quantity theory of money, if the amount of money in an economy double, all else equal, price levels will also double. This means that the consumer will pay twice as much for the same amount of goods and services. This increase in price levels will eventually result in a rising inflation level; inflation is a measure of the rate of rising prices of goods and services in an economy.
The same forces that influence the supply and demand of any commodity also influence the supply and demand of money: an increase in the supply of money decreases the marginal value of money–in other words, when the money supply increases, but with all else being equal or ceteris paribus, the buying capacity of one unit of currency decreases. As a way of adjusting for this decrease in money's marginal value, the prices of goods and services rises; this results in a higher inflation level.
The Quantity Theory of Money refers to the idea that the quantity of money available (money supply) grows at the same rate as price levels do in the long run. When interest rates fall or taxes decrease and the access to money becomes less restricted, consumers become less sensitive to price changes and, thus, will have a higher propensity to consume. As a result, the aggregate demand curve will shift right, thus shifting up the equilibrium price level.
Exchange Equation
To better understand the Quantity Theory of Money, we can use the Exchange Equation. The equation enables economists to model the relationship between money supply and price levels. The exchange equation is:
M.V = P.Q
Where:
M – refers to the money supply
V – refers to the Velocity of Money, which measures how much a single dollar of money supply spend contributes to GDP
P – refers to the prevailing price level
Q – refers to the quantity of goods and services produced in the economy
Holding Q and V constant, we can see that increases in the money supply will cause price levels to increase, thus causing inflation. The assumption that Q and V are constant holds in the long run as these factors cannot be influenced by changes in the economy’s money supply.
The theory provides a quick overview of monetarist theory, which states that changes in the current money supply cause fluctuations in overall economic output; excessive growth in money supply causes hikes in inflation.
Q5) What is an Index number?
A5) An index number is a statistical derive to measure changes in the value of money. It is a number which represents the average price of a group of commodities at a particular time in relation to the average price of the same group of commodities at another time.
Professor Chandler defines it thus – “An index number of prices is a figure showing the height of average prices at one time relative to their height at some other time that is taken at the base period.”
Q6) What are the methods of Construction of Index Number?
A6) In constructing an index number, the following steps should be noted:
1. Purpose of the Index Number: Before constructing an index number, it should be decided the purpose for which it is needed. An index number constructed for one category or purpose cannot be used for others. A cost-of-living index of working classes cannot be used for farmers because the items entering into their consumption will be different.
2. Selection of Commodities:
Commodities to be selected depend upon the purpose or objective of the index number to be constructed. But the number of commodities should neither be too large nor too small. Moreover, commodities to be selected must be broadly representative of the group of commodities. They should also be comparable in the sense that standard or graded items should be taken.
3. Selection of Prices:
The next step is to select the prices of these commodities. For this purpose, care should be taken to select prices from representative persons, places or journals or other sources. But they must be reliable. Prices may be quoted in money terms i.e., Rs. 100 per quantal or in quantity terms, i.e., 2 kg per rupee.
Care should be taken not to mix these prices. Then the problem is to select wholesale or retail prices. This depends on the type of index number. For a consumer price index, wholesale prices are required, for a cost-of-living index, retail prices are needed. But different prices should not be mixed up.
4. Selection of an Average:
Since index numbers are averages, the problem is how to select an appropriate average. The two important averages are the arithmetic mean and geometric mean. The arithmetic mean is the simpler of the two. But geometric mean is more accurate. However, the average prices should be reduced to price relatives (percentages) either on the basis of the fixed base method or the chain base method.
5. Selection of Weights:
While constructing an index number due weightage or importance should be given to the various commodities. Commodities which are more important in the consumption of consumers should be given higher weightage than other commodities. The weights are determined with reference to the relative amounts of income spent on commodities by consumers. Weights may be given in terms of value or quantity.
6. Selection of the Base Period:
The selection of the base period is the most important step in the construction of an index number. It is a period against which comparisons are made. The base period should be normal and free from any unusual events such as war, famine, earthquake, drought, boom, etc. It should not be either very recent or remote.
7. Selection of Formula:
A number of formulas have been devised to construct an index number. But the selection of an appropriate formula depends upon the availability of data and purpose of the index number. No single formula may be used for all types of index numbers.
Q7) What is Monetary policy?
A7) Monetary policy is a set of tools that a nation's central bank has available to promote sustainable economic growth by controlling the overall supply of money that is available to the nation's banks, its consumers, and its businesses.
The goal is to keep the economy humming along at a rate that is neither too hot nor too cold. The central bank may force up interest rates on borrowing in order to discourage spending or force down interest rates to inspire more borrowing and spending.
The main weapon at its disposal is the nation's money. The central bank sets the rates it charges to loan money to the nation's banks. When it raises or lowers its rates, all financial institutions tweak the rates they charge all of their customers, from big businesses borrowing for major projects to home buyers applying for mortgages.
All of those customers are rate-sensitive. They're more likely to borrow when rates are low and put off borrowing when rates are high.
Q8) Explain the tools of monetary policy.
A8) Central banks use various tools to implement monetary policies. The widely utilized policy tools include:
1. Interest rate adjustment
A central bank can influence interest rates by changing the discount rate. The discount rate (base rate) is an interest rate charged by a central bank to banks for short-term loans. For example, if a central bank increases the discount rate, the cost of borrowing for the banks increases. Subsequently, the banks will increase the interest rate they charge their customers. Thus, the cost of borrowing in the economy will increase, and the money supply will decrease.
2. Change reserve requirements
Central banks usually set up the minimum number of reserves that must be held by a commercial bank. By changing the required amount, the central bank can influence the money supply in the economy. If monetary authorities increase the required reserve amount, commercial banks find less money available to lend to their clients and thus, money supply decreases.
Commercial banks can’t use the reserves to make loans or fund investments into new businesses. Since it constitutes a lost opportunity for the commercial banks, central banks pay them interest on the reserves. The interest is known as IOR or IORR (interest on reserves or interest on required reserves).
3. Open market operations
The central bank can either purchase or sell securities issued by the government to affect the money supply. For example, central banks can purchase government bonds. As a result, banks will obtain more money to increase the lending and money supply in the economy.
Q9) What is Indian Money Market?
A9) Money Market is a segment of the financial market in India where borrowing and lending of short-term funds take place. The maturity of money market instruments is from one day to one year. In India, this market is regulated by both RBI (the Reserve bank of India) and SEBI (the Security and Exchange Board of India). The nature of transactions in this market is such that they are large in amount and high in volume. Thus, we can say that the entire market is dominated by a small number of large players.
Q10) Explain the structure of organized money market of India.
A10) The organized money market in India is not a single market. It is a combination of markets of various instruments. The following are the instruments that are integral parts of the Indian money market system.
1. Call money or notice money
Call money, notice money, and term money markets are sub-markets of the Indian money market. These markets provide funds for very short-term. Lending and borrowing from the call money market for 1 day.
Whereas lending and borrowing of funds from notice money market are for 2 to 14 days. And when there are borrowing and lending of funds for the tenor of more than 14 days, it refers to “Term Money”.
2. Treasury bills
The Bill market is a sub-market of this market in India. There are two types of the bill in the money market. They are treasury bills and commercial bill. The treasury bills are also known as T-Bills, T-bills are issued by the Central bank on behalf of Government, whereas Commercial Bills are issued by Financial Institutions.
Treasury bills do not yield any interest, but it is issued at discount and repaid at par at the time of maturity. In T-bills there is no risk of default; it is a safe investment instrument.
3. Commercial bills
Commercial bill is a money market instrument which is similar to the bill of exchange; it is issued by a Commercial organization to raise money for short-term needs. In India, the participants of the commercial bill market are banks and financial institutions.
4.Certificate of deposits
Certificate of Deposits also known as CDs. It is a negotiable money market instrument. It is like a promissory note. Rates, terms, and amounts vary from institution to institution. CDs are not supposed to trade publicly neither it is traded on any exchange.
In general institutions issue certificate of deposit at discount on its face value. The banks and financial institutions can issue CDs on a floating rate basis.
5. Commercial paper
The commercial paper is another money market instrument in India. We also call commercial paper as CP. CP refers to a short-term unsecured money market instrument. Big corporations with good credit rating issue commercial paper as a promissory note. There is no collateral support for CPs. Hence, only large firms with considerable financial strength can issue the instrument.
6. Money market mutual funds (MMMFs)
The money-market mutual funds were introduced by RBI in 1992 and since 2000 they are brought under the regulation of SEBI. It is an open-ended mutual fund which invests in short-term debt securities. This kind of mutual fund solely invests in instruments of the money market.
7. Repo and the reverse repo market
Repo means “Repurchase Agreement”. It exists in India since December 1992. REPO means selling a security under an agreement to repurchase it at a predetermined date and rate. Those who deal in government securities they use the repo as an overnight borrowing.
Q11) How Inflation can become a destructive force in an economy?
A11) Inflation can become a destructive force in an economy, however, when it is allowed to get out of hand and rise dramatically. Unchecked inflation can topple a country’s economy, like in 2018 when Venezuela’s inflation rate hit over 1,000,000% a month, causing the economy to collapse and forcing countless citizens to flee the country.
The impact inflation has on the time value of money is that it decreases the value of a dollar over time. The time value of money is a concept that describes how the money available to you today is worth more than the same amount of money at a future date.
This also assumes you do not invest the money available to you today in an equity security, a debt instrument, or an interest-bearing bank account. Essentially, if you have a dollar in your pocket today, that dollars’ worth, or value, will be lower one year from today if you keep it in your pocket.
Inflation increases the price of goods and services over time, effectively decreasing the number of goods and services you can buy with a dollar in the future as opposed to a dollar today. If wages remain the same but inflation causes the prices of goods and services to increase over time, it will take a larger percentage of your income to purchase the same good or service in the future.
Q12) How deflation works?
A12) When deflation is occurring, consumers often slow their spending since they expect prices to fall further. Businesses too, delay spending, which can lead to a slowdown in economic growth since consumer and business spending are two key drivers for growth.
Deflation tightens the money supply because there's an increase in real interest rates, causing consumers to save money. It hinders the revenue growth of firms, potentially causing lower wages and layoffs for workers. This cycle leads to higher unemployment rates and lower growth rates.
Deflation is the opposite of inflation, which represents widespread price increases of goods and services in an economy.
Q13) Give example of Deflation's Impact on the National Debt.
A13) Let's say as an example, the government of Greece owed $100 billion to the United States in the previous year. Thinking in terms of oil, the government could have bought 100 million barrels of oil. However, this year, Greece is experiencing a deflationary period and could buy 200 million barrels of oil with the same amount, since the prices of goods and services have decreased. However, its debt has stayed the same, but now the country is actually paying more–200 million barrels of oil as opposed to 100 million. In other words, after deflation, Greece would be paying the U.S. 200 million barrels of oil worth of money to pay their debt. As a result, deflation can cause the real value of national debt to rise.
Q14) What are Defensive stocks?
A14) Defensive stocks are those of companies that sell products or services that we people can't easily cut out of their lives. Consumer goods and utilities are two of the most common examples.
Think of toilet paper, food, and electricity. No matter what the economic conditions are, people will always need these goods and services.
If you don't want to invest in individual stocks, you could invest in ETFs that track the Dow Jones U.S. Consumer Goods Index or the Dow Jones U.S. Utilities Index.
For consumer goods, popular ETFs include iShares US Consumer Goods (IYK) and ProShares Ultra Consumer Goods (UGE). And ETF options for utilities include iShares US Utilities (IDU) and ProShares Ultra Utilities (UPW).
Q15) What are Dividend paying stocks?
A15) Dividend-paying stocks remain in demand during a recession because of their income. While the stock price may decline, investors can count on the dividends to continue providing steady passive income.
Investors should focus on high-quality dividend-paying companies, rather than simply seeking companies that have high dividend yields. An abnormally-high dividend yield may actually be a warning sign because it could indicate that the stock's price has recently taken a nosedive.
If you're looking for strong, dividend-paying companies, the "Dividend Aristocrats" can be a great place to start. Dividend aristocrats are companies that have increased their dividends for at least 25 consecutive years. As of September 2021, there are 63 companies that meet these requirements.
Q16) What are Investment grade bonds?
A16) Investment-grade bonds include Treasuries and those of high-quality, blue-chip companies. These types of bonds work well during a deflationary environment because of the quality of the entity behind them.
The government isn’t going broke, which means investors can have confidence that they’ll continue to receive regular payments and eventually their principal.
It’s the same with high-quality companies. These companies have been around for a long time, have great management and solid balance sheets. Their products are in demand. It’s unlikely these companies will go out of business, even during a recession.
Q17) Give the Exchange equation to understand the Quantity Theory of Money.
A17) To better understand the Quantity Theory of Money, we can use the Exchange Equation. The equation enables economists to model the relationship between money supply and price levels. The exchange equation is:
M.V = P.Q
Where:
M – refers to the money supply
V – refers to the Velocity of Money, which measures how much a single dollar of money supply spend contributes to GDP
P – refers to the prevailing price level
Q – refers to the quantity of goods and services produced in the economy
Holding Q and V constant, we can see that increases in the money supply will cause price levels to increase, thus causing inflation. The assumption that Q and V are constant holds in the long run as these factors cannot be influenced by changes in the economy’s money supply.
The theory provides a quick overview of monetarist theory, which states that changes in the current money supply cause fluctuations in overall economic output; excessive growth in money supply causes hikes in inflation.
Q18) What are the points to be noted to understand the meaning of the term index number?
A18) First, an average figure relates to a single group of commodities. But the various items in the group are expressed in different units. For example, a consumer price index contains such diverse items as food, clothing, fuel and lighting, house rent, and miscellaneous things. Food consists of wheat, ghee, etc. expressed in kgs. Cloth is expressed in metres, and lighting in kws. An index number expresses the average of all such diverse items in different units.
Second, an index number measures the net increase or decrease of the average prices for the group under study. For instance, if the consumer price index has increased from 150 in 1982 as compared to 100 in 1980, it shows a net increase of 50 per cent in the prices of commodities included in the index.
Third, an index number measures the extent of changes in the value of money (or price level) over a period of time, given a base period. If the base period is the year 1970, we can measure change in the average price level for the preceding and succeeding years.
Q19) What are the primary objectives of monetary policies?
A19) The primary objectives of monetary policies are the management of inflation or unemployment, and maintenance of currency exchange rates.
1. Inflation
Monetary policies can target inflation levels. A low level of inflation is considered to be healthy for the economy. If inflation is high, a contractionary policy can address this issue.
2. Unemployment
Monetary policies can influence the level of unemployment in the economy. For example, an expansionary monetary policy generally decreases unemployment because the higher money supply stimulates business activities that lead to the expansion of the job market.
3. Currency exchange rates
Using its fiscal authority, a central bank can regulate the exchange rates between domestic and foreign currencies. For example, the central bank may increase the money supply by issuing more currency. In such a case, the domestic currency becomes cheaper relative to its foreign counterparts.
Q20) What are the objectives of Indian Money market?
A20) The following are the important objectives of an Indian money market –
- Facilitate a parking place to employ short-term surplus funds.
- Aid room for overcoming short-term deficits.
- To enable the Central Bank to influence and regulate liquidity in the economy through its intervention in this market.
- Help reasonable access to users of short-term funds to meet their requirements quickly, adequately and at reasonable costs.
Segments of the Indian money market
- The Indian money-market has the following two segments. The existence of the unorganized market, though illegal, yet operates. However, we that is out of the scope of the present article. So, we will concentrate exclusively on the organized money-markets in India. Wherever, in the blog article or elsewhere in the site we refer money-markets, it is in organized money-market only.
1. Unorganized money-market
- The unorganized money market is an old and ancient market, mainly it made of indigenous bankers and money lenders, etc.
2. Organized money-market
- The organized money market is that part which comes under the regulatory ambit of RBI & SEBI. Governments (Central and State), Discount and Finance House of India (DFHI), Mutual Funds, Corporate, Commercial or Cooperative Banks, Public Sector Undertakings, Insurance Companies, and Financial Institutions and Non-Banking Financial Companies (NBFCs) are the key players of the organized Indian money market.
Unit 2
Changes in the Value of Money and its Measurements
Q1) What is Inflation?
A1) Inflation refers to the broad increase in prices across a sector or an industry, like the automotive or energy business—and ultimately a country’s entire economy. The chief measures of U.S. Inflation are the Consumer Price Index (CPI), the Producer Price Index (PPI) and the Personal Consumption Expenditures Price Index (PCE), all of which use varying measures to track the change in prices consumers pay and producers receive in industries across the whole American economy.
Inflation occurs when prices rise, decreasing the purchasing power of your dollars. In 1980, for example, a movie ticket cost on average $2.89. By 2019, the average price of a movie ticket had risen to $9.16. If you saved a $10 bill from 1980, it would buy two fewer movie tickets in 2019 than it would have nearly four decades earlier.
Though it can be frustrating to think about your dollars losing value, most economists consider a small amount of inflation a sign of a healthy economy. A moderate inflation rate encourages you to spend or invest your money today, rather than stuff it under your mattress and watch its value diminish.
Q2) What is Deflation?
A2) When the overall price level decreases so that inflation rate becomes negative, it is called deflation. It is the opposite of the often-encountered inflation.
During times of deflation, since the money supply is tightened, there is an increase in the value of money, which increases the real value of debt. Since money is valued more highly during deflationary periods, borrowers are actually paying more because the debt payments remain unchanged.
Deflation is a scenario where there are falling prices of goods and services across the economy. Although the ability to purchase goods and services at a discount may sound like an ideal situation, it has the potential to cause a lot of problems throughout the economy. Some of the negative side effects of deflation are a decrease in consumer spending, increased interest rates, and an increase in the real value of debt.
Real Value of Debt
All of these problems can increase the real value of debt. During times of deflation, since the money supply is tightened, there is an increase in the value of money, which increases the real value of debt. Most debt payments, such as mortgages, are fixed, and when prices fall during deflation, the cost of debt remains at the old level. In other words, in real terms–which factors in price changes–the debt levels have increased.
As a result, it can become harder for borrowers to pay their debts. Since money is valued more highly during deflationary periods, borrowers are actually paying more because the debt payments remain unchanged.
Example of Deflation's Impact on the National Debt
Let's say as an example, the government of Greece owed $100 billion to the United States in the previous year. Thinking in terms of oil, the government could have bought 100 million barrels of oil. However, this year, Greece is experiencing a deflationary period and could buy 200 million barrels of oil with the same amount, since the prices of goods and services have decreased. However, its debt has stayed the same, but now the country is actually paying more–200 million barrels of oil as opposed to 100 million. In other words, after deflation, Greece would be paying the U.S. 200 million barrels of oil worth of money to pay their debt. As a result, deflation can cause the real value of national debt to rise.
Q3) What are the best investments for deflationary period?
A3) For many, deflationary periods are marked by conservation and even survival. But for some, they're able to maintain their investments and continue without a significant decrease in their lifestyle.
Deflation may sound like a great time for investors because prices are falling. But the problem is that prices can keep falling. There's no way to know for sure when the bottom has been reached.
Rather than chasing prices lower, it may be better to look at investments that maintain their value or at least don't drop as fast. Below are three examples of investments that tend to remain durable during deflationary periods.
1. Investment-Grade Bonds
Investment-grade bonds include Treasuries and those of high-quality, blue-chip companies. These types of bonds work well during a deflationary environment because of the quality of the entity behind them.
The government isn’t going broke, which means investors can have confidence that they’ll continue to receive regular payments and eventually their principal.
It’s the same with high-quality companies. These companies have been around for a long time, have great management and solid balance sheets. Their products are in demand. It’s unlikely these companies will go out of business, even during a recession.
2. Defensive Stocks
Defensive stocks are those of companies that sell products or services that we people can't easily cut out of their lives. Consumer goods and utilities are two of the most common examples.
Think of toilet paper, food, and electricity. No matter what the economic conditions are, people will always need these goods and services.
If you don't want to invest in individual stocks, you could invest in ETFs that track the Dow Jones U.S. Consumer Goods Index or the Dow Jones U.S. Utilities Index.
For consumer goods, popular ETFs include iShares US Consumer Goods (IYK) and ProShares Ultra Consumer Goods (UGE). And ETF options for utilities include iShares US Utilities (IDU) and ProShares Ultra Utilities (UPW).
3. Dividend-Paying Stocks
Dividend-paying stocks remain in demand during a recession because of their income. While the stock price may decline, investors can count on the dividends to continue providing steady passive income.
Investors should focus on high-quality dividend-paying companies, rather than simply seeking companies that have high dividend yields. An abnormally-high dividend yield may actually be a warning sign because it could indicate that the stock's price has recently taken a nosedive.
If you're looking for strong, dividend-paying companies, the "Dividend Aristocrats" can be a great place to start. Dividend aristocrats are companies that have increased their dividends for at least 25 consecutive years. As of September 2021, there are 63 companies that meet these requirements.
Q4) Explain Quantity theory of money.
A4) Monetary economics is a branch of economics that studies different theories of money. One of the primary research areas for this branch of economics is the quantity theory of money (QTM). According to the quantity theory of money, the general price level of goods and services is proportional to the money supply in an economy. While this theory was originally formulated by Polish mathematician Nicolaus Copernicus in 1517, it was popularized later by economists Milton Friedman and Anna Schwartz after the publication of their book, "A Monetary History of the United States, 1867-1960," in 1963.1
According to the quantity theory of money, if the amount of money in an economy double, all else equal, price levels will also double. This means that the consumer will pay twice as much for the same amount of goods and services. This increase in price levels will eventually result in a rising inflation level; inflation is a measure of the rate of rising prices of goods and services in an economy.
The same forces that influence the supply and demand of any commodity also influence the supply and demand of money: an increase in the supply of money decreases the marginal value of money–in other words, when the money supply increases, but with all else being equal or ceteris paribus, the buying capacity of one unit of currency decreases. As a way of adjusting for this decrease in money's marginal value, the prices of goods and services rises; this results in a higher inflation level.
The Quantity Theory of Money refers to the idea that the quantity of money available (money supply) grows at the same rate as price levels do in the long run. When interest rates fall or taxes decrease and the access to money becomes less restricted, consumers become less sensitive to price changes and, thus, will have a higher propensity to consume. As a result, the aggregate demand curve will shift right, thus shifting up the equilibrium price level.
Exchange Equation
To better understand the Quantity Theory of Money, we can use the Exchange Equation. The equation enables economists to model the relationship between money supply and price levels. The exchange equation is:
M.V = P.Q
Where:
M – refers to the money supply
V – refers to the Velocity of Money, which measures how much a single dollar of money supply spend contributes to GDP
P – refers to the prevailing price level
Q – refers to the quantity of goods and services produced in the economy
Holding Q and V constant, we can see that increases in the money supply will cause price levels to increase, thus causing inflation. The assumption that Q and V are constant holds in the long run as these factors cannot be influenced by changes in the economy’s money supply.
The theory provides a quick overview of monetarist theory, which states that changes in the current money supply cause fluctuations in overall economic output; excessive growth in money supply causes hikes in inflation.
Q5) What is an Index number?
A5) An index number is a statistical derive to measure changes in the value of money. It is a number which represents the average price of a group of commodities at a particular time in relation to the average price of the same group of commodities at another time.
Professor Chandler defines it thus – “An index number of prices is a figure showing the height of average prices at one time relative to their height at some other time that is taken at the base period.”
Q6) What are the methods of Construction of Index Number?
A6) In constructing an index number, the following steps should be noted:
1. Purpose of the Index Number: Before constructing an index number, it should be decided the purpose for which it is needed. An index number constructed for one category or purpose cannot be used for others. A cost-of-living index of working classes cannot be used for farmers because the items entering into their consumption will be different.
2. Selection of Commodities:
Commodities to be selected depend upon the purpose or objective of the index number to be constructed. But the number of commodities should neither be too large nor too small. Moreover, commodities to be selected must be broadly representative of the group of commodities. They should also be comparable in the sense that standard or graded items should be taken.
3. Selection of Prices:
The next step is to select the prices of these commodities. For this purpose, care should be taken to select prices from representative persons, places or journals or other sources. But they must be reliable. Prices may be quoted in money terms i.e., Rs. 100 per quantal or in quantity terms, i.e., 2 kg per rupee.
Care should be taken not to mix these prices. Then the problem is to select wholesale or retail prices. This depends on the type of index number. For a consumer price index, wholesale prices are required, for a cost-of-living index, retail prices are needed. But different prices should not be mixed up.
4. Selection of an Average:
Since index numbers are averages, the problem is how to select an appropriate average. The two important averages are the arithmetic mean and geometric mean. The arithmetic mean is the simpler of the two. But geometric mean is more accurate. However, the average prices should be reduced to price relatives (percentages) either on the basis of the fixed base method or the chain base method.
5. Selection of Weights:
While constructing an index number due weightage or importance should be given to the various commodities. Commodities which are more important in the consumption of consumers should be given higher weightage than other commodities. The weights are determined with reference to the relative amounts of income spent on commodities by consumers. Weights may be given in terms of value or quantity.
6. Selection of the Base Period:
The selection of the base period is the most important step in the construction of an index number. It is a period against which comparisons are made. The base period should be normal and free from any unusual events such as war, famine, earthquake, drought, boom, etc. It should not be either very recent or remote.
7. Selection of Formula:
A number of formulas have been devised to construct an index number. But the selection of an appropriate formula depends upon the availability of data and purpose of the index number. No single formula may be used for all types of index numbers.
Q7) What is Monetary policy?
A7) Monetary policy is a set of tools that a nation's central bank has available to promote sustainable economic growth by controlling the overall supply of money that is available to the nation's banks, its consumers, and its businesses.
The goal is to keep the economy humming along at a rate that is neither too hot nor too cold. The central bank may force up interest rates on borrowing in order to discourage spending or force down interest rates to inspire more borrowing and spending.
The main weapon at its disposal is the nation's money. The central bank sets the rates it charges to loan money to the nation's banks. When it raises or lowers its rates, all financial institutions tweak the rates they charge all of their customers, from big businesses borrowing for major projects to home buyers applying for mortgages.
All of those customers are rate-sensitive. They're more likely to borrow when rates are low and put off borrowing when rates are high.
Q8) Explain the tools of monetary policy.
A8) Central banks use various tools to implement monetary policies. The widely utilized policy tools include:
1. Interest rate adjustment
A central bank can influence interest rates by changing the discount rate. The discount rate (base rate) is an interest rate charged by a central bank to banks for short-term loans. For example, if a central bank increases the discount rate, the cost of borrowing for the banks increases. Subsequently, the banks will increase the interest rate they charge their customers. Thus, the cost of borrowing in the economy will increase, and the money supply will decrease.
2. Change reserve requirements
Central banks usually set up the minimum number of reserves that must be held by a commercial bank. By changing the required amount, the central bank can influence the money supply in the economy. If monetary authorities increase the required reserve amount, commercial banks find less money available to lend to their clients and thus, money supply decreases.
Commercial banks can’t use the reserves to make loans or fund investments into new businesses. Since it constitutes a lost opportunity for the commercial banks, central banks pay them interest on the reserves. The interest is known as IOR or IORR (interest on reserves or interest on required reserves).
3. Open market operations
The central bank can either purchase or sell securities issued by the government to affect the money supply. For example, central banks can purchase government bonds. As a result, banks will obtain more money to increase the lending and money supply in the economy.
Q9) What is Indian Money Market?
A9) Money Market is a segment of the financial market in India where borrowing and lending of short-term funds take place. The maturity of money market instruments is from one day to one year. In India, this market is regulated by both RBI (the Reserve bank of India) and SEBI (the Security and Exchange Board of India). The nature of transactions in this market is such that they are large in amount and high in volume. Thus, we can say that the entire market is dominated by a small number of large players.
Q10) Explain the structure of organized money market of India.
A10) The organized money market in India is not a single market. It is a combination of markets of various instruments. The following are the instruments that are integral parts of the Indian money market system.
1. Call money or notice money
Call money, notice money, and term money markets are sub-markets of the Indian money market. These markets provide funds for very short-term. Lending and borrowing from the call money market for 1 day.
Whereas lending and borrowing of funds from notice money market are for 2 to 14 days. And when there are borrowing and lending of funds for the tenor of more than 14 days, it refers to “Term Money”.
2. Treasury bills
The Bill market is a sub-market of this market in India. There are two types of the bill in the money market. They are treasury bills and commercial bill. The treasury bills are also known as T-Bills, T-bills are issued by the Central bank on behalf of Government, whereas Commercial Bills are issued by Financial Institutions.
Treasury bills do not yield any interest, but it is issued at discount and repaid at par at the time of maturity. In T-bills there is no risk of default; it is a safe investment instrument.
3. Commercial bills
Commercial bill is a money market instrument which is similar to the bill of exchange; it is issued by a Commercial organization to raise money for short-term needs. In India, the participants of the commercial bill market are banks and financial institutions.
4.Certificate of deposits
Certificate of Deposits also known as CDs. It is a negotiable money market instrument. It is like a promissory note. Rates, terms, and amounts vary from institution to institution. CDs are not supposed to trade publicly neither it is traded on any exchange.
In general institutions issue certificate of deposit at discount on its face value. The banks and financial institutions can issue CDs on a floating rate basis.
5. Commercial paper
The commercial paper is another money market instrument in India. We also call commercial paper as CP. CP refers to a short-term unsecured money market instrument. Big corporations with good credit rating issue commercial paper as a promissory note. There is no collateral support for CPs. Hence, only large firms with considerable financial strength can issue the instrument.
6. Money market mutual funds (MMMFs)
The money-market mutual funds were introduced by RBI in 1992 and since 2000 they are brought under the regulation of SEBI. It is an open-ended mutual fund which invests in short-term debt securities. This kind of mutual fund solely invests in instruments of the money market.
7. Repo and the reverse repo market
Repo means “Repurchase Agreement”. It exists in India since December 1992. REPO means selling a security under an agreement to repurchase it at a predetermined date and rate. Those who deal in government securities they use the repo as an overnight borrowing.
Q11) How Inflation can become a destructive force in an economy?
A11) Inflation can become a destructive force in an economy, however, when it is allowed to get out of hand and rise dramatically. Unchecked inflation can topple a country’s economy, like in 2018 when Venezuela’s inflation rate hit over 1,000,000% a month, causing the economy to collapse and forcing countless citizens to flee the country.
The impact inflation has on the time value of money is that it decreases the value of a dollar over time. The time value of money is a concept that describes how the money available to you today is worth more than the same amount of money at a future date.
This also assumes you do not invest the money available to you today in an equity security, a debt instrument, or an interest-bearing bank account. Essentially, if you have a dollar in your pocket today, that dollars’ worth, or value, will be lower one year from today if you keep it in your pocket.
Inflation increases the price of goods and services over time, effectively decreasing the number of goods and services you can buy with a dollar in the future as opposed to a dollar today. If wages remain the same but inflation causes the prices of goods and services to increase over time, it will take a larger percentage of your income to purchase the same good or service in the future.
Q12) How deflation works?
A12) When deflation is occurring, consumers often slow their spending since they expect prices to fall further. Businesses too, delay spending, which can lead to a slowdown in economic growth since consumer and business spending are two key drivers for growth.
Deflation tightens the money supply because there's an increase in real interest rates, causing consumers to save money. It hinders the revenue growth of firms, potentially causing lower wages and layoffs for workers. This cycle leads to higher unemployment rates and lower growth rates.
Deflation is the opposite of inflation, which represents widespread price increases of goods and services in an economy.
Q13) Give example of Deflation's Impact on the National Debt.
A13) Let's say as an example, the government of Greece owed $100 billion to the United States in the previous year. Thinking in terms of oil, the government could have bought 100 million barrels of oil. However, this year, Greece is experiencing a deflationary period and could buy 200 million barrels of oil with the same amount, since the prices of goods and services have decreased. However, its debt has stayed the same, but now the country is actually paying more–200 million barrels of oil as opposed to 100 million. In other words, after deflation, Greece would be paying the U.S. 200 million barrels of oil worth of money to pay their debt. As a result, deflation can cause the real value of national debt to rise.
Q14) What are Defensive stocks?
A14) Defensive stocks are those of companies that sell products or services that we people can't easily cut out of their lives. Consumer goods and utilities are two of the most common examples.
Think of toilet paper, food, and electricity. No matter what the economic conditions are, people will always need these goods and services.
If you don't want to invest in individual stocks, you could invest in ETFs that track the Dow Jones U.S. Consumer Goods Index or the Dow Jones U.S. Utilities Index.
For consumer goods, popular ETFs include iShares US Consumer Goods (IYK) and ProShares Ultra Consumer Goods (UGE). And ETF options for utilities include iShares US Utilities (IDU) and ProShares Ultra Utilities (UPW).
Q15) What are Dividend paying stocks?
A15) Dividend-paying stocks remain in demand during a recession because of their income. While the stock price may decline, investors can count on the dividends to continue providing steady passive income.
Investors should focus on high-quality dividend-paying companies, rather than simply seeking companies that have high dividend yields. An abnormally-high dividend yield may actually be a warning sign because it could indicate that the stock's price has recently taken a nosedive.
If you're looking for strong, dividend-paying companies, the "Dividend Aristocrats" can be a great place to start. Dividend aristocrats are companies that have increased their dividends for at least 25 consecutive years. As of September 2021, there are 63 companies that meet these requirements.
Q16) What are Investment grade bonds?
A16) Investment-grade bonds include Treasuries and those of high-quality, blue-chip companies. These types of bonds work well during a deflationary environment because of the quality of the entity behind them.
The government isn’t going broke, which means investors can have confidence that they’ll continue to receive regular payments and eventually their principal.
It’s the same with high-quality companies. These companies have been around for a long time, have great management and solid balance sheets. Their products are in demand. It’s unlikely these companies will go out of business, even during a recession.
Q17) Give the Exchange equation to understand the Quantity Theory of Money.
A17) To better understand the Quantity Theory of Money, we can use the Exchange Equation. The equation enables economists to model the relationship between money supply and price levels. The exchange equation is:
M.V = P.Q
Where:
M – refers to the money supply
V – refers to the Velocity of Money, which measures how much a single dollar of money supply spend contributes to GDP
P – refers to the prevailing price level
Q – refers to the quantity of goods and services produced in the economy
Holding Q and V constant, we can see that increases in the money supply will cause price levels to increase, thus causing inflation. The assumption that Q and V are constant holds in the long run as these factors cannot be influenced by changes in the economy’s money supply.
The theory provides a quick overview of monetarist theory, which states that changes in the current money supply cause fluctuations in overall economic output; excessive growth in money supply causes hikes in inflation.
Q18) What are the points to be noted to understand the meaning of the term index number?
A18) First, an average figure relates to a single group of commodities. But the various items in the group are expressed in different units. For example, a consumer price index contains such diverse items as food, clothing, fuel and lighting, house rent, and miscellaneous things. Food consists of wheat, ghee, etc. expressed in kgs. Cloth is expressed in metres, and lighting in kws. An index number expresses the average of all such diverse items in different units.
Second, an index number measures the net increase or decrease of the average prices for the group under study. For instance, if the consumer price index has increased from 150 in 1982 as compared to 100 in 1980, it shows a net increase of 50 per cent in the prices of commodities included in the index.
Third, an index number measures the extent of changes in the value of money (or price level) over a period of time, given a base period. If the base period is the year 1970, we can measure change in the average price level for the preceding and succeeding years.
Q19) What are the primary objectives of monetary policies?
A19) The primary objectives of monetary policies are the management of inflation or unemployment, and maintenance of currency exchange rates.
1. Inflation
Monetary policies can target inflation levels. A low level of inflation is considered to be healthy for the economy. If inflation is high, a contractionary policy can address this issue.
2. Unemployment
Monetary policies can influence the level of unemployment in the economy. For example, an expansionary monetary policy generally decreases unemployment because the higher money supply stimulates business activities that lead to the expansion of the job market.
3. Currency exchange rates
Using its fiscal authority, a central bank can regulate the exchange rates between domestic and foreign currencies. For example, the central bank may increase the money supply by issuing more currency. In such a case, the domestic currency becomes cheaper relative to its foreign counterparts.
Q20) What are the objectives of Indian Money market?
A20) The following are the important objectives of an Indian money market –
- Facilitate a parking place to employ short-term surplus funds.
- Aid room for overcoming short-term deficits.
- To enable the Central Bank to influence and regulate liquidity in the economy through its intervention in this market.
- Help reasonable access to users of short-term funds to meet their requirements quickly, adequately and at reasonable costs.
Segments of the Indian money market
- The Indian money-market has the following two segments. The existence of the unorganized market, though illegal, yet operates. However, we that is out of the scope of the present article. So, we will concentrate exclusively on the organized money-markets in India. Wherever, in the blog article or elsewhere in the site we refer money-markets, it is in organized money-market only.
1. Unorganized money-market
- The unorganized money market is an old and ancient market, mainly it made of indigenous bankers and money lenders, etc.
2. Organized money-market
- The organized money market is that part which comes under the regulatory ambit of RBI & SEBI. Governments (Central and State), Discount and Finance House of India (DFHI), Mutual Funds, Corporate, Commercial or Cooperative Banks, Public Sector Undertakings, Insurance Companies, and Financial Institutions and Non-Banking Financial Companies (NBFCs) are the key players of the organized Indian money market.
Unit 2
Changes in the Value of Money and its Measurements
Q1) What is Inflation?
A1) Inflation refers to the broad increase in prices across a sector or an industry, like the automotive or energy business—and ultimately a country’s entire economy. The chief measures of U.S. Inflation are the Consumer Price Index (CPI), the Producer Price Index (PPI) and the Personal Consumption Expenditures Price Index (PCE), all of which use varying measures to track the change in prices consumers pay and producers receive in industries across the whole American economy.
Inflation occurs when prices rise, decreasing the purchasing power of your dollars. In 1980, for example, a movie ticket cost on average $2.89. By 2019, the average price of a movie ticket had risen to $9.16. If you saved a $10 bill from 1980, it would buy two fewer movie tickets in 2019 than it would have nearly four decades earlier.
Though it can be frustrating to think about your dollars losing value, most economists consider a small amount of inflation a sign of a healthy economy. A moderate inflation rate encourages you to spend or invest your money today, rather than stuff it under your mattress and watch its value diminish.
Q2) What is Deflation?
A2) When the overall price level decreases so that inflation rate becomes negative, it is called deflation. It is the opposite of the often-encountered inflation.
During times of deflation, since the money supply is tightened, there is an increase in the value of money, which increases the real value of debt. Since money is valued more highly during deflationary periods, borrowers are actually paying more because the debt payments remain unchanged.
Deflation is a scenario where there are falling prices of goods and services across the economy. Although the ability to purchase goods and services at a discount may sound like an ideal situation, it has the potential to cause a lot of problems throughout the economy. Some of the negative side effects of deflation are a decrease in consumer spending, increased interest rates, and an increase in the real value of debt.
Real Value of Debt
All of these problems can increase the real value of debt. During times of deflation, since the money supply is tightened, there is an increase in the value of money, which increases the real value of debt. Most debt payments, such as mortgages, are fixed, and when prices fall during deflation, the cost of debt remains at the old level. In other words, in real terms–which factors in price changes–the debt levels have increased.
As a result, it can become harder for borrowers to pay their debts. Since money is valued more highly during deflationary periods, borrowers are actually paying more because the debt payments remain unchanged.
Example of Deflation's Impact on the National Debt
Let's say as an example, the government of Greece owed $100 billion to the United States in the previous year. Thinking in terms of oil, the government could have bought 100 million barrels of oil. However, this year, Greece is experiencing a deflationary period and could buy 200 million barrels of oil with the same amount, since the prices of goods and services have decreased. However, its debt has stayed the same, but now the country is actually paying more–200 million barrels of oil as opposed to 100 million. In other words, after deflation, Greece would be paying the U.S. 200 million barrels of oil worth of money to pay their debt. As a result, deflation can cause the real value of national debt to rise.
Q3) What are the best investments for deflationary period?
A3) For many, deflationary periods are marked by conservation and even survival. But for some, they're able to maintain their investments and continue without a significant decrease in their lifestyle.
Deflation may sound like a great time for investors because prices are falling. But the problem is that prices can keep falling. There's no way to know for sure when the bottom has been reached.
Rather than chasing prices lower, it may be better to look at investments that maintain their value or at least don't drop as fast. Below are three examples of investments that tend to remain durable during deflationary periods.
1. Investment-Grade Bonds
Investment-grade bonds include Treasuries and those of high-quality, blue-chip companies. These types of bonds work well during a deflationary environment because of the quality of the entity behind them.
The government isn’t going broke, which means investors can have confidence that they’ll continue to receive regular payments and eventually their principal.
It’s the same with high-quality companies. These companies have been around for a long time, have great management and solid balance sheets. Their products are in demand. It’s unlikely these companies will go out of business, even during a recession.
2. Defensive Stocks
Defensive stocks are those of companies that sell products or services that we people can't easily cut out of their lives. Consumer goods and utilities are two of the most common examples.
Think of toilet paper, food, and electricity. No matter what the economic conditions are, people will always need these goods and services.
If you don't want to invest in individual stocks, you could invest in ETFs that track the Dow Jones U.S. Consumer Goods Index or the Dow Jones U.S. Utilities Index.
For consumer goods, popular ETFs include iShares US Consumer Goods (IYK) and ProShares Ultra Consumer Goods (UGE). And ETF options for utilities include iShares US Utilities (IDU) and ProShares Ultra Utilities (UPW).
3. Dividend-Paying Stocks
Dividend-paying stocks remain in demand during a recession because of their income. While the stock price may decline, investors can count on the dividends to continue providing steady passive income.
Investors should focus on high-quality dividend-paying companies, rather than simply seeking companies that have high dividend yields. An abnormally-high dividend yield may actually be a warning sign because it could indicate that the stock's price has recently taken a nosedive.
If you're looking for strong, dividend-paying companies, the "Dividend Aristocrats" can be a great place to start. Dividend aristocrats are companies that have increased their dividends for at least 25 consecutive years. As of September 2021, there are 63 companies that meet these requirements.
Q4) Explain Quantity theory of money.
A4) Monetary economics is a branch of economics that studies different theories of money. One of the primary research areas for this branch of economics is the quantity theory of money (QTM). According to the quantity theory of money, the general price level of goods and services is proportional to the money supply in an economy. While this theory was originally formulated by Polish mathematician Nicolaus Copernicus in 1517, it was popularized later by economists Milton Friedman and Anna Schwartz after the publication of their book, "A Monetary History of the United States, 1867-1960," in 1963.1
According to the quantity theory of money, if the amount of money in an economy double, all else equal, price levels will also double. This means that the consumer will pay twice as much for the same amount of goods and services. This increase in price levels will eventually result in a rising inflation level; inflation is a measure of the rate of rising prices of goods and services in an economy.
The same forces that influence the supply and demand of any commodity also influence the supply and demand of money: an increase in the supply of money decreases the marginal value of money–in other words, when the money supply increases, but with all else being equal or ceteris paribus, the buying capacity of one unit of currency decreases. As a way of adjusting for this decrease in money's marginal value, the prices of goods and services rises; this results in a higher inflation level.
The Quantity Theory of Money refers to the idea that the quantity of money available (money supply) grows at the same rate as price levels do in the long run. When interest rates fall or taxes decrease and the access to money becomes less restricted, consumers become less sensitive to price changes and, thus, will have a higher propensity to consume. As a result, the aggregate demand curve will shift right, thus shifting up the equilibrium price level.
Exchange Equation
To better understand the Quantity Theory of Money, we can use the Exchange Equation. The equation enables economists to model the relationship between money supply and price levels. The exchange equation is:
M.V = P.Q
Where:
M – refers to the money supply
V – refers to the Velocity of Money, which measures how much a single dollar of money supply spend contributes to GDP
P – refers to the prevailing price level
Q – refers to the quantity of goods and services produced in the economy
Holding Q and V constant, we can see that increases in the money supply will cause price levels to increase, thus causing inflation. The assumption that Q and V are constant holds in the long run as these factors cannot be influenced by changes in the economy’s money supply.
The theory provides a quick overview of monetarist theory, which states that changes in the current money supply cause fluctuations in overall economic output; excessive growth in money supply causes hikes in inflation.
Q5) What is an Index number?
A5) An index number is a statistical derive to measure changes in the value of money. It is a number which represents the average price of a group of commodities at a particular time in relation to the average price of the same group of commodities at another time.
Professor Chandler defines it thus – “An index number of prices is a figure showing the height of average prices at one time relative to their height at some other time that is taken at the base period.”
Q6) What are the methods of Construction of Index Number?
A6) In constructing an index number, the following steps should be noted:
1. Purpose of the Index Number: Before constructing an index number, it should be decided the purpose for which it is needed. An index number constructed for one category or purpose cannot be used for others. A cost-of-living index of working classes cannot be used for farmers because the items entering into their consumption will be different.
2. Selection of Commodities:
Commodities to be selected depend upon the purpose or objective of the index number to be constructed. But the number of commodities should neither be too large nor too small. Moreover, commodities to be selected must be broadly representative of the group of commodities. They should also be comparable in the sense that standard or graded items should be taken.
3. Selection of Prices:
The next step is to select the prices of these commodities. For this purpose, care should be taken to select prices from representative persons, places or journals or other sources. But they must be reliable. Prices may be quoted in money terms i.e., Rs. 100 per quantal or in quantity terms, i.e., 2 kg per rupee.
Care should be taken not to mix these prices. Then the problem is to select wholesale or retail prices. This depends on the type of index number. For a consumer price index, wholesale prices are required, for a cost-of-living index, retail prices are needed. But different prices should not be mixed up.
4. Selection of an Average:
Since index numbers are averages, the problem is how to select an appropriate average. The two important averages are the arithmetic mean and geometric mean. The arithmetic mean is the simpler of the two. But geometric mean is more accurate. However, the average prices should be reduced to price relatives (percentages) either on the basis of the fixed base method or the chain base method.
5. Selection of Weights:
While constructing an index number due weightage or importance should be given to the various commodities. Commodities which are more important in the consumption of consumers should be given higher weightage than other commodities. The weights are determined with reference to the relative amounts of income spent on commodities by consumers. Weights may be given in terms of value or quantity.
6. Selection of the Base Period:
The selection of the base period is the most important step in the construction of an index number. It is a period against which comparisons are made. The base period should be normal and free from any unusual events such as war, famine, earthquake, drought, boom, etc. It should not be either very recent or remote.
7. Selection of Formula:
A number of formulas have been devised to construct an index number. But the selection of an appropriate formula depends upon the availability of data and purpose of the index number. No single formula may be used for all types of index numbers.
Q7) What is Monetary policy?
A7) Monetary policy is a set of tools that a nation's central bank has available to promote sustainable economic growth by controlling the overall supply of money that is available to the nation's banks, its consumers, and its businesses.
The goal is to keep the economy humming along at a rate that is neither too hot nor too cold. The central bank may force up interest rates on borrowing in order to discourage spending or force down interest rates to inspire more borrowing and spending.
The main weapon at its disposal is the nation's money. The central bank sets the rates it charges to loan money to the nation's banks. When it raises or lowers its rates, all financial institutions tweak the rates they charge all of their customers, from big businesses borrowing for major projects to home buyers applying for mortgages.
All of those customers are rate-sensitive. They're more likely to borrow when rates are low and put off borrowing when rates are high.
Q8) Explain the tools of monetary policy.
A8) Central banks use various tools to implement monetary policies. The widely utilized policy tools include:
1. Interest rate adjustment
A central bank can influence interest rates by changing the discount rate. The discount rate (base rate) is an interest rate charged by a central bank to banks for short-term loans. For example, if a central bank increases the discount rate, the cost of borrowing for the banks increases. Subsequently, the banks will increase the interest rate they charge their customers. Thus, the cost of borrowing in the economy will increase, and the money supply will decrease.
2. Change reserve requirements
Central banks usually set up the minimum number of reserves that must be held by a commercial bank. By changing the required amount, the central bank can influence the money supply in the economy. If monetary authorities increase the required reserve amount, commercial banks find less money available to lend to their clients and thus, money supply decreases.
Commercial banks can’t use the reserves to make loans or fund investments into new businesses. Since it constitutes a lost opportunity for the commercial banks, central banks pay them interest on the reserves. The interest is known as IOR or IORR (interest on reserves or interest on required reserves).
3. Open market operations
The central bank can either purchase or sell securities issued by the government to affect the money supply. For example, central banks can purchase government bonds. As a result, banks will obtain more money to increase the lending and money supply in the economy.
Q9) What is Indian Money Market?
A9) Money Market is a segment of the financial market in India where borrowing and lending of short-term funds take place. The maturity of money market instruments is from one day to one year. In India, this market is regulated by both RBI (the Reserve bank of India) and SEBI (the Security and Exchange Board of India). The nature of transactions in this market is such that they are large in amount and high in volume. Thus, we can say that the entire market is dominated by a small number of large players.
Q10) Explain the structure of organized money market of India.
A10) The organized money market in India is not a single market. It is a combination of markets of various instruments. The following are the instruments that are integral parts of the Indian money market system.
1. Call money or notice money
Call money, notice money, and term money markets are sub-markets of the Indian money market. These markets provide funds for very short-term. Lending and borrowing from the call money market for 1 day.
Whereas lending and borrowing of funds from notice money market are for 2 to 14 days. And when there are borrowing and lending of funds for the tenor of more than 14 days, it refers to “Term Money”.
2. Treasury bills
The Bill market is a sub-market of this market in India. There are two types of the bill in the money market. They are treasury bills and commercial bill. The treasury bills are also known as T-Bills, T-bills are issued by the Central bank on behalf of Government, whereas Commercial Bills are issued by Financial Institutions.
Treasury bills do not yield any interest, but it is issued at discount and repaid at par at the time of maturity. In T-bills there is no risk of default; it is a safe investment instrument.
3. Commercial bills
Commercial bill is a money market instrument which is similar to the bill of exchange; it is issued by a Commercial organization to raise money for short-term needs. In India, the participants of the commercial bill market are banks and financial institutions.
4.Certificate of deposits
Certificate of Deposits also known as CDs. It is a negotiable money market instrument. It is like a promissory note. Rates, terms, and amounts vary from institution to institution. CDs are not supposed to trade publicly neither it is traded on any exchange.
In general institutions issue certificate of deposit at discount on its face value. The banks and financial institutions can issue CDs on a floating rate basis.
5. Commercial paper
The commercial paper is another money market instrument in India. We also call commercial paper as CP. CP refers to a short-term unsecured money market instrument. Big corporations with good credit rating issue commercial paper as a promissory note. There is no collateral support for CPs. Hence, only large firms with considerable financial strength can issue the instrument.
6. Money market mutual funds (MMMFs)
The money-market mutual funds were introduced by RBI in 1992 and since 2000 they are brought under the regulation of SEBI. It is an open-ended mutual fund which invests in short-term debt securities. This kind of mutual fund solely invests in instruments of the money market.
7. Repo and the reverse repo market
Repo means “Repurchase Agreement”. It exists in India since December 1992. REPO means selling a security under an agreement to repurchase it at a predetermined date and rate. Those who deal in government securities they use the repo as an overnight borrowing.
Q11) How Inflation can become a destructive force in an economy?
A11) Inflation can become a destructive force in an economy, however, when it is allowed to get out of hand and rise dramatically. Unchecked inflation can topple a country’s economy, like in 2018 when Venezuela’s inflation rate hit over 1,000,000% a month, causing the economy to collapse and forcing countless citizens to flee the country.
The impact inflation has on the time value of money is that it decreases the value of a dollar over time. The time value of money is a concept that describes how the money available to you today is worth more than the same amount of money at a future date.
This also assumes you do not invest the money available to you today in an equity security, a debt instrument, or an interest-bearing bank account. Essentially, if you have a dollar in your pocket today, that dollars’ worth, or value, will be lower one year from today if you keep it in your pocket.
Inflation increases the price of goods and services over time, effectively decreasing the number of goods and services you can buy with a dollar in the future as opposed to a dollar today. If wages remain the same but inflation causes the prices of goods and services to increase over time, it will take a larger percentage of your income to purchase the same good or service in the future.
Q12) How deflation works?
A12) When deflation is occurring, consumers often slow their spending since they expect prices to fall further. Businesses too, delay spending, which can lead to a slowdown in economic growth since consumer and business spending are two key drivers for growth.
Deflation tightens the money supply because there's an increase in real interest rates, causing consumers to save money. It hinders the revenue growth of firms, potentially causing lower wages and layoffs for workers. This cycle leads to higher unemployment rates and lower growth rates.
Deflation is the opposite of inflation, which represents widespread price increases of goods and services in an economy.
Q13) Give example of Deflation's Impact on the National Debt.
A13) Let's say as an example, the government of Greece owed $100 billion to the United States in the previous year. Thinking in terms of oil, the government could have bought 100 million barrels of oil. However, this year, Greece is experiencing a deflationary period and could buy 200 million barrels of oil with the same amount, since the prices of goods and services have decreased. However, its debt has stayed the same, but now the country is actually paying more–200 million barrels of oil as opposed to 100 million. In other words, after deflation, Greece would be paying the U.S. 200 million barrels of oil worth of money to pay their debt. As a result, deflation can cause the real value of national debt to rise.
Q14) What are Defensive stocks?
A14) Defensive stocks are those of companies that sell products or services that we people can't easily cut out of their lives. Consumer goods and utilities are two of the most common examples.
Think of toilet paper, food, and electricity. No matter what the economic conditions are, people will always need these goods and services.
If you don't want to invest in individual stocks, you could invest in ETFs that track the Dow Jones U.S. Consumer Goods Index or the Dow Jones U.S. Utilities Index.
For consumer goods, popular ETFs include iShares US Consumer Goods (IYK) and ProShares Ultra Consumer Goods (UGE). And ETF options for utilities include iShares US Utilities (IDU) and ProShares Ultra Utilities (UPW).
Q15) What are Dividend paying stocks?
A15) Dividend-paying stocks remain in demand during a recession because of their income. While the stock price may decline, investors can count on the dividends to continue providing steady passive income.
Investors should focus on high-quality dividend-paying companies, rather than simply seeking companies that have high dividend yields. An abnormally-high dividend yield may actually be a warning sign because it could indicate that the stock's price has recently taken a nosedive.
If you're looking for strong, dividend-paying companies, the "Dividend Aristocrats" can be a great place to start. Dividend aristocrats are companies that have increased their dividends for at least 25 consecutive years. As of September 2021, there are 63 companies that meet these requirements.
Q16) What are Investment grade bonds?
A16) Investment-grade bonds include Treasuries and those of high-quality, blue-chip companies. These types of bonds work well during a deflationary environment because of the quality of the entity behind them.
The government isn’t going broke, which means investors can have confidence that they’ll continue to receive regular payments and eventually their principal.
It’s the same with high-quality companies. These companies have been around for a long time, have great management and solid balance sheets. Their products are in demand. It’s unlikely these companies will go out of business, even during a recession.
Q17) Give the Exchange equation to understand the Quantity Theory of Money.
A17) To better understand the Quantity Theory of Money, we can use the Exchange Equation. The equation enables economists to model the relationship between money supply and price levels. The exchange equation is:
M.V = P.Q
Where:
M – refers to the money supply
V – refers to the Velocity of Money, which measures how much a single dollar of money supply spend contributes to GDP
P – refers to the prevailing price level
Q – refers to the quantity of goods and services produced in the economy
Holding Q and V constant, we can see that increases in the money supply will cause price levels to increase, thus causing inflation. The assumption that Q and V are constant holds in the long run as these factors cannot be influenced by changes in the economy’s money supply.
The theory provides a quick overview of monetarist theory, which states that changes in the current money supply cause fluctuations in overall economic output; excessive growth in money supply causes hikes in inflation.
Q18) What are the points to be noted to understand the meaning of the term index number?
A18) First, an average figure relates to a single group of commodities. But the various items in the group are expressed in different units. For example, a consumer price index contains such diverse items as food, clothing, fuel and lighting, house rent, and miscellaneous things. Food consists of wheat, ghee, etc. expressed in kgs. Cloth is expressed in metres, and lighting in kws. An index number expresses the average of all such diverse items in different units.
Second, an index number measures the net increase or decrease of the average prices for the group under study. For instance, if the consumer price index has increased from 150 in 1982 as compared to 100 in 1980, it shows a net increase of 50 per cent in the prices of commodities included in the index.
Third, an index number measures the extent of changes in the value of money (or price level) over a period of time, given a base period. If the base period is the year 1970, we can measure change in the average price level for the preceding and succeeding years.
Q19) What are the primary objectives of monetary policies?
A19) The primary objectives of monetary policies are the management of inflation or unemployment, and maintenance of currency exchange rates.
1. Inflation
Monetary policies can target inflation levels. A low level of inflation is considered to be healthy for the economy. If inflation is high, a contractionary policy can address this issue.
2. Unemployment
Monetary policies can influence the level of unemployment in the economy. For example, an expansionary monetary policy generally decreases unemployment because the higher money supply stimulates business activities that lead to the expansion of the job market.
3. Currency exchange rates
Using its fiscal authority, a central bank can regulate the exchange rates between domestic and foreign currencies. For example, the central bank may increase the money supply by issuing more currency. In such a case, the domestic currency becomes cheaper relative to its foreign counterparts.
Q20) What are the objectives of Indian Money market?
A20) The following are the important objectives of an Indian money market –
- Facilitate a parking place to employ short-term surplus funds.
- Aid room for overcoming short-term deficits.
- To enable the Central Bank to influence and regulate liquidity in the economy through its intervention in this market.
- Help reasonable access to users of short-term funds to meet their requirements quickly, adequately and at reasonable costs.
Segments of the Indian money market
- The Indian money-market has the following two segments. The existence of the unorganized market, though illegal, yet operates. However, we that is out of the scope of the present article. So, we will concentrate exclusively on the organized money-markets in India. Wherever, in the blog article or elsewhere in the site we refer money-markets, it is in organized money-market only.
1. Unorganized money-market
- The unorganized money market is an old and ancient market, mainly it made of indigenous bankers and money lenders, etc.
2. Organized money-market
- The organized money market is that part which comes under the regulatory ambit of RBI & SEBI. Governments (Central and State), Discount and Finance House of India (DFHI), Mutual Funds, Corporate, Commercial or Cooperative Banks, Public Sector Undertakings, Insurance Companies, and Financial Institutions and Non-Banking Financial Companies (NBFCs) are the key players of the organized Indian money market.
