Principles of Economics Chapter 10

Sajjad Ahmad Malik

RISE PREMIER SCHOOL OF ACCOUNTANCY
 CHAPTER 10

PART-01: INTRODUCTION TO MONEY

1.1: BARTER SYSTEM: (Era of Absence of Money)

‘Barter is the exchange of one economic good or service for another’.

There are several problems with barter system:

1. Lack of double coincidence of wants:

Fundamental condition for barter system to take place is the existence of ‘coincidence of wants.
It refers to a situation where both parties (buyers and sellers) are able to offer something which
is acceptable for each of them simultaneously.

2. Difficult to decide Rate of exchange:

It is very difficult to decide Rate of exchange in barter that is agreed by both parties.

3. Lack of Storing/saving:
In barter system, storing of wealth was difficult, specially perishable goods.

4. Lack of Divisibility:
Sometime it is not possible to divide the goods to exchange for goods, e.g. a cow cannot b devided
into smaller units.

5. Transfer of wealth:
Transfer of immovable goods like house was not possible.

6. Difficulties in Tax collection/ Government Spening :

If tax is collected in form of goods, it is not possible to spend it on development projects.

MONEY AND ITS EVOLUTION

Money:
An officially-issued legal tender that is generally acceptable as a medium of exchange and at the same time
acts as a measure and a store of value

Evolution of money:
Money evolved with passage of time.

Stages of evolution of money:

1. Commodity money
Commodity money system is where goods are exchanged for making transaction (such asanimals,
stones, bones, tobacco, arrows etc., were used as medium of exchange.

2. Metallic money
As the human civilization progressed, the only commodities used as means of exchange became
metals such as gold and silver.
• These metals have intrinsic value.

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• It is too dangerous to carry them
• gold and silver are scarce in nature
• In case of discoveries of ore deposits, gold/ silver may be in abundance.

There were TWO types of metallic money:

• Full bodied money: It refers to that form of money in which the intrinsic value (value
of themetal used in that coin) is equal to the face value (value printed on coin).
• Token money: It refers to that form of money in which the intrinsic value is less than its
facevalue.

3. Paper money:
Paper money is a piece of printed paper with engraving on it by government.
There are following main kinds of paper money:
• Convertible: The government promises to change this currency into gold if demanded.
• Inconvertible: Against such money the government has no promise to give gold if
demanded.
• Fiat Money: It is also an inconvertible money and is a form of paper money that is not
backed by gold etc.
Advantages of Paper Money:
• It does not require precious metals. The printing of currency notes is simple and cheaper than
minting coins.
• It helps government to increase money supply to finance its development projects without
imposing new taxes.
• Paper money is easy to transfer as compared to metallic money.

Disadvantages of Paper Money

• Danger of inflation due to over issuance.
• weaker currencies usually accepted within country not outside.
• Paper money has limited age than coins, as it can be torn or burned

4. Bank money:
It is not itself money but it performs all the functions of money like cheques.

5. Credit money:
A contractual agreement whereby a borrower receives something of value in the present, in
exchange for payment in the future, generally with interest, e.g. bonds, IOUs

Advantages of credit money

• Allows immediate consumption of expensive goods, based on future earnings (this includes
houses, education, cars, which could otherwise not be bought).
• Allows firms to invest, expand and generate future revenue, rather than using retained earnings.
• Government can also increase its spending by issuing bonds which is a type of credit.

Disadvantages of credit money

• There is risk of bad debts.
• Credit may also cause of inflation

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6. Electronic money:
Such as Debit and Credit cards, online payments (Bank transfer through mobile applications, Jazz Cash
and Easy paisa)

7. Digital money:
Such as Bitcoin (Crypto currencies are decentralized networks based on blockchain technology.)
(Crypto currencies are Not in our syllabus, Its only for informative purpose)

1.3: FUNCTIONS AND CHARACTERISTICS OF MONEY

Functions of Money:
1. To act as a medium of exchange:
Allowing economic agents to exchange goods without the need to barter.

2. To act as a unit of account:

Allowing people to compare the relative price of goods and services through a common
denomination.

3. To act as a store of value:

Money can be stored and saved for future consumption.

4. To act as a standard of deferred payments:

If someone buy a good now and want to pay in future, the amount will also be paid in money.

Characteristics of Money:
1. General Acceptability:
A good money is generally accepted throughout the economy.

2. Stability: A good money should be stable. If value of money will be unstable, then it cannot
perform its function as a measure of value and especially as a standard of deferred payments.

3. Durability:
Money should be durable, retain the same shape and substance, and not deteriorate over an
extended period of time.

4. Transportability:
Money can be easily moved between locations.

5. Divisibility:
money can be divided into small denominations to facilitate transactions

6. Non-counterfeitability:
It should not be easily duplicated. It will fail as a medium of exchange if people can create
money easily. So, government should use secret elements (such as watermarking) to make the
processof duplication more difficult.

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1.4: VIEWS OF ECONOMIST ABOUT ROLE OF MONEY

• Classical economists
➢ Classical economists believed that there should be no demand for money, as money is
neutral.
➢ Money is used to balance out the forces of demand and supply in the market system.
➢ Money plays a passive role in the economy.
• Keynesian economists
➢ Keynesian believed that there is demand for money to influence aggregate demand.
➢ Money also acts as a store of value.
➢ Money can be used to purchase goods and services in the future.
• Monetarist’s economist:
➢ Monetarists believed that aggregate expenditures in the economy are influenced by the
marketrate of interest.
➢ If monetary policies are used to increase aggregate demand, employment and
economic growth, it may cause a short-term boost in output but will ultimately lead to
inflationin the economy.

PART-02: DEMAND FOR MONEY

Definition:
• ‘All else equal, demand for money is the amount of money which people wish to hold at a
given time at different rates of interest’.
• In other words, demand for money is the desired amount of holding financial assets in form
of cash or bank deposit (rather than making investment).
• In Nutshell, demand for money is the desire to holding cash or liquid assets.

Factors affecting demand for money:

1. Interest Rate: (Primary determinant)

Higher interest rate decreases the demand for money and vice versa.
Interest is the opportunity cost of holding liquid assets. Instead of holding cash one can earn
handsome amount of interest by lending it to someone else.
Demand Schedule and Demand Curve:

Demand for Money Schedule Rate of Interest “r”

Demand for
Rate of Interest
Money 10%
(%)
(Rs. Billions)
10 100 8%

8 200 6%

6 300
MD
4 400
2 500 Money demand

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Rate of Interest “r”

2. Increase in financial innovation:
Increase in Financial innovations such as Debit
Card, Credit Card and Electronic payments
reduce demand for liquid assets and will cause
leftward shift in MD Curve.

MD
MD1

Money demand

3. Level of GDP: Rate of Interest “r”

• Real income and employment increase due
to an increase in GDP.
10%
• This will cause an increase in the demand
for money and there is an outward shift in
8%
the demand for money

4. Level of Prices: 6%
Increase in general price level, increase the MD1
demand for money MD

MD1 MD2 MD3

Money demand

2.1: KEYNES’ LIQUIDITY PREFERENCE THEORY:

Liquidity preference theory states that all factors remaining the same, people prefer to hold cash
(liquidity) rather than illiquid assets (Bond).
They will, however, be paid a premium (interest) to hold more illiquid assets.
There is inverse relationship between rate of interest and money demanded”.

Motives of Holding Money in Liquid Form:

1. Transactional motives:
• People hold money to carry day to day transactions.
• This depends upon the level of income. The higher the level of income the higher will be the
transactions motive.
• Transactional demand for money remains unaffected to any change in rate of interest (perfectly
inelastic).

2. Precautionary motives:
• People’s desire to save money for unforeseen circumstances such as accident or disease etc.
• This motive will depend on the nature of the individual and on the conditions in which he
lives.
• Precautionary demand for money is inversely related to market rate of interest but relatively
inelastic.

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3. Speculative motives:
• People want to make more money with their existing money stock.
• People hold money to take advantages of changes in price of bonds.
• Money held for speculative motives depends on market rate of interest. If market rate of
interest is high (and prices of bonds are low), people buy bonds and sell them when price of
bond increases.
• Speculative demand for money is also inversely related to the interest rate but relatively elastic.

Bond:
An investment that is bought up front by an investor, and which then pays a fixed amount in return
at regular time periods (usually annually).
Bond price = 1 / rate of interest
Example:
• Suppose a bond is issued for Rs.4,000, and its annual return is Rs.400 (which is fixed). This
means the annual rate ofinterest is 10%.
• If the market interest rate falls to 5%, then the price of the bond will increase to Rs.8,000. This is
because, in order to maintain an annual return of Rs.400, Rs.8,000 would need to be invested in
another asset.

• There is an inverse relationship between the rate of interest, and the speculative demand for
money.
• There is inverse relationship between market interest rate and price of a bond.

Total demand for money:

Aggregating the transactional, precautionary and speculative demand for money, we get the total
demand for money. This is sometimes known as the liquidity preference curve, and is inversely
relatedto the rate of interest.

Total Demand Transactional Precautionary Speculative

for Money (MD) = Demand for + Demand for + Demand for
Money Money Money

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KEYNES’ LIQUIDITY TRAP:

• Interest rates are near zero (called critical rate of interest), leaving no room for further rate
cuts.
• Fear of economic uncertainty leads households and businesses to save more money.
• Any effort to change in interest by changing money supply becomes useless.
• According to Keynes Liquidity Trap, people wait for good time for purchasing bonds. They
prefer to hold liquid money (cash balances) which makes monetary policy ineffective.

Rate of Interest Liquidity Preference Curve

MS1 MS2 MS3

Liquidity Trap

r0 MD

M1 M2
Demand for Money and Supply

Overcoming the liquidity trap:

A number of policies can help to break out of the liquidity trap:

• Expansionary Fiscal policy:

Though monetary policy is ineffective, Fiscal policy can increase aggregate demand by
government spending.

• Rising inflation expectations:

Inflationary expectations can turn liquid funds into consumption/ investment as higher
inflation will cause savings to be worthless.

• Increase in interest rates: If interest rate increases, it will decrease the price of bond and
people will start purchasing bonds and with this inflow of resources into financial system,
economy will slowly pull out from the liquidity trap.

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PART-03: SUPPLY OF MONEY: (MS)

Supply of Money:
Total amount of money in circulation or in existence in a country at a given time. It includes
currency notes, currency coins, banks demand deposits etc.

3.1: TYPES OF MONEY:

Types of money categorized by its liquidity:

1. Transactional money (M0): which is used to buy and sell things within an Economy.
M0 = Notes and Coins in circulation.

2. Checking accounts (M1): money that is in peoples’ accounts that they have immediate access
M1 = M0 + current account (demand deposits)

3. Savings deposits (M2): money that belongs to people, but which they cannot access immediately.
M2 = M1 + saving account (Time deposits)

4. Large time assets (M3): M3 = M2 + institutional money market funds (Long term deposits).

Note:
As we move from M0 to onward, money become illiquid. supply of money must be limited.

Importance of money supply:

Lowering the interest rate, make borrowing easy for people causes increase in money supply
which directly affecting the level of investment and consumption within an economy.

3.2: METODS OF CONTROLLING THE MONEY SUPPLY:

There are various means by which the government can attempt to control the money supply.

1. Open market operations

Buying and selling of government securities by the central bank in open market. selling of
government securities decrease money supply and vice versa.

2. Interest rates
If the government raises interest rates this reduces the demand for money since less people will
want to take out bank loans, thus less money is created. (a contractionary monetary policy.)

3. Reserve Ratio:
A government can require commercial banks to deposit a certain proportion of their assets at the
central bank to control money supply.

4. Government borrowing
The government can influence the money supply with the level of its own borrowing:
• higher borrowing by the government reduces the money supply;
• lower borrowing by the government increases the money supply.

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3.3: QUANTITY THEORY OF MONEY:

Quantity theory of money:

An eminent economist “Irving Fisher” states that supply of money is directly proportion to Price
level and inversely proportion to the value of money.

Money supply 𝖺 price level

Money supply 1/𝖺 value of money

thus, Value of money 1/𝖺 Price level

‘Quantity Theory of Money states that Velocity of money (V) and total goods and services (T)
remaining unchanged, changes quantity of money supplied cause direct and proportional change in
price level’
.
Mathematically,
MV = PT
• M=Money supplied,
• V=Velocity of circulation of money (rate at which money is exchanged in an economy in a
given time).
• P=Price level,
• T = total goods and services
Example:
Suppose, in a given condition of an economy;
M = 100 (Rs. billions), V = 10, P = 20, T = 50 (million units)
Keeping V and T constant, if M becomes twice i.e 200, then the price level will be calculated as follows:
𝐌𝐕 = 𝐏𝐓
𝐌𝐕
P=
𝐓
𝟐𝟎𝟎𝐱𝟏𝟎
P=
𝟓𝟎
P = 𝟒𝟎
Hence, as we double the money supply (M), price level is doubled which means that value of money
has fallen to one half.

CALCULATION OF VELOCITY (V): V = GDP / Supply of Money

Assumptions of the Theory:

• Velocity of money remains constant.
• Amount of goods and services remain unchanged.
• Money is required to spend on goods and services.
• ‘P’ is a passive factor which is affected by other factors.
• Full employment has reached in economy

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PART-04: RATE OF INTEREST

INTEREST RATE:
Interest is the amount charged by a lender to a borrower on the principal borrowed. Interest rate is
calculated on the percentage of principal and on per annum basis.

• Nominal interest rate: (rate with inflation)

Nominal interest rate is the actual interest rate paid on any borrowing.

Example:
if a borrower pays Rs. 10 on every 100 rupees lent to him. The nominal interest rate is 10%.

• Real interest rate:

It is the rate without inflation. (Inflation adjusted.)

Example:
if a bond compounds annually and has a nominal interest rate of 10% and the inflation rate is
6% then the real interest rate is only 4%.

Determinants of Interest Rate:

Supply and demand for credit Money

• The interest rate depends upon the supply and demand of credit money.
An increase in demand of credit money would lead to an increase in the rate of interest
(and vice-versa).
• An increase in the supply of credit money would decrease the rate of interest (and vice-versa).

Determination of Interest Rate

MS
Market rate of interest (%)

M
ar
ke
t
R
at
e
o
f
In
te
re
st
(
%
)
MD

Demand and Supply (Money)

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Change in supply of money:

Government will try to increase interest rate by reducing Money supply in an

economy to shrinkconsumption, inflation and investment in the country. This will
happen when:

• Central bank will sell securities in open market

• Bank reserves will decline
• Commercial banks have less lending power
• Overall money supply will fall
• Inflation rate will be low

Note: All the factors are reversed with decrease the interest rate

MS2 MS MS1
Market rate of interest

r2

r1

MD

M2 M M1
Demand and Supply (Money)

In the graph, due to increase in money supply the MS shift to MS1 which lowering the
interest rate tor1. While a decrease in money supply shift MS to MS2 which cause an
increase in interest rate to r2

Process of changing interest rate due to different policies adopted by central bank is given
below:

Money goes Commercial Less funds

Selling of Money Interest rate
to central Bank reserves available for
securities supply falls goes up
bank decreases lending

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