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A MODEL MONEY SUPPLY

Prepared by :

Amrut Bharwad(06)

Kamlesh Bharwad(25)

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MONEY

Money is any object or record that is generally accepted as

payment for goods and services and repayment ofdebts in a given

country or socio-economic context.

The main functions of money are distinguished as: a medium of

exchange; a unit of account; a store of value; and, occasionally in

the past, a standard of deferred payment.

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HISTORY OF MONEY

The use ofbarter-like methods may date back to

at least 100,000 years ago, though there is no

evidence of a society or economy that relied

primarily on barter. Instead, non-monetary societies operated largely

along the principles ofgift economics. When

barter did occur, it was usually between either

complete strangers or potential enemies.

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TYPES OF MONEY

Commodity money: Many items have been used as commoditymoney such as naturally scarce precious metals, conch shells,

barley, beads etc., as well as many other things that are thought of

as having value.

Representative money: In 1875 economist William Stanley Jevonsdescribed what he called "representative money," i.e., money that

consists oftoken coins

, or other physical tokens such as certificates,

that can be reliably exchanged for a fixed quantity of a commodity

such as gold or silver.

Fiat money: Fiat money or fiat currency is money whose value is not

derived from any intrinsic value or guarantee that it can be

converted into a valuable commodity (such as gold).

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MONETARY POLICY

Governments and central banks have taken bothregulatory and free market approaches to monetary

policy. Some of the tools used to control the money

supply include:

changing the interest rate at which the central bank

loans money to (or borrows money from) the

commercial banks

currency purchases or sales

increasing or lowering government borrowing

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CONTDincreasing or lowering government spending

manipulation ofexchange rates

raising or lowering bank reserve requirements

regulation or prohibition ofprivate currenciestaxation or tax breaks on imports or exports of capital

into a country

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MONEY SUPPLY

From economics, the money supply or money stock, isthe total amount ofmoney available in an economy at a

specific time.

There are several ways to define "money," but standard

measures usually include currency in circulation and

demand deposits (depositors' easily accessed assets on

the books of financial institutions).

That relation between money and prices is historicallyassociated with the quantity theory of money.

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MEASUREMENT OF MONEY SUPPLY

In India, there are four alternative measures of money supply, popularly known

as M1, M2, M3 and M4.

M1Measurement

M1 = C + DD +OD

C : it refers to currency and includes coins and paper notes held by

the public

DD : it refers to demand deposits of the people with the

commercial banks. These are chequeable deposits which can bewithdrawn or transferred on demand.

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CONTD.

OD : other deposits which include demand deposits with RBI of

public financial institutions like IDBI; demand deposits with RBI of

foreign central banks and of the foreign governments; demand

deposits of international financial institutions like IMF and World

Bank

Only net demand deposits are included in money supply.

Distinction may be drawn between gross demand deposits and net

demand deposits with the commercial banks.G

ross demanddeposits include inter-banking claims: claim of one bank against

the other. Net demand deposits do not include inter banking

claims. Inter-banking claims are not the part of demand deposits

of the people

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CONTD..

M2Measurement

It is a broader concept of the supply of moneycompared to M1. Besides all the components of M1, it

also includes the savings of the people with the post

offices. Thus,

M2= M1+Deposits with Post Office saving bank

account

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CONTD.

M3 Measurement

M3 is also broader concept of money supply compared to M1. Besides

all the components of M1, it includes, (net) time deposits (or fixed

deposits/or term deposits)of the people with the commercial banks.

Thus,

M3=M1 + net time deposits with the commercial banks

M4 Measurement

M4 concept is much broader then M3. Besides all the components of

M3, it also includes total deposits with the post offices (other than in theform of National Saving Certificate.) Thus,

M4= M3 + Total Deposits with post offices (other than NSC)

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WHO SUPPLIES MONEY?

In the modern times, the sources of supply of money are

government, central bank of the country and commercial banks.

In India, it is ministry of finance that issues one-rupee notes and

all the coins.

Money is mainly supplied by the Reserve Bank of India which is

central bank of the country. RBI issues currency on the basis of

minimum reserve system

When the commercial banks provide credit to the people or

buy the securities sold by the RBI then they add to the supply of

money. On other hand when they contract credit, there is fall in

the supply of money.

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HOWDOES GOVERNMENT CONTROL MS?

Generally speaking contractionary monetary policies

and expansionary monetary policies involve changing

the level of the money supply in a country. Expansionary

monetary policy is simply a policy which expands

(increases) the supply of money, whereas contractionary

monetary policy contracts (decreases) the supply of a

country's currency.

Expansionary Monetary Policy:

1. Purchase securities on the open market, known

as Open Market Operations

2. Lower the Federal Discount Rate

3. Lower Reserve Requirements

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WHAT IS RBI'S MONETARY POLICY?

The Reserve Bank of India will announce its

Monetary and Credit Policy for the first half of

the financial year 2002-03 on April 29. Even as

RBI Governor Bimal Jalan puts the finishing

touches to the document, have you ever

considered what is the significance of the

biannual exercise?

This policy determines the supply of money in the

economy and the rate of interest charged bybanks. The policy also contains an economic

overview and presents future forecasts.

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THE IS-LM MODEL

The IS-LM model translates the General Theory of Keynes intoneoclassical terms (often called the neoclassic synthesis )

It was proposed by John Hicks in 1937 in a paper called Mr Keynesand the "Classics": A Suggested Interpretation and enhanced by Alvin

Hansen (hence it is also called the Hicks-Hansen model).

The model examines the combined equilibrium of two markets :

y The goods market, which is at equilibrium when investments equalsavings, hence IS.

y The money market, which is at equilibrium when the demand forliquidity equals money supply, hence LM.

y Examining the joint equilibrium in these two markets allows us todetermine two variables : output Y and the interest rate i.

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THE IS-LM MODEL

The model rests on two fundamental assumptions

y All prices (including wages) are fixed.

y There exists excess production capacity in the economy

This is a complete change in perspective compared to classical economics:y The level of demand determines the level of output and employment.

y There can be an equilibrium level of involuntary unemployment.

Why can there be insufficient demand ?

y Criticism of Says law: Uncertainty can lead to precautionary saving ratherthan consumption.

y Monetary criticism: the preference for liquidity can lead to under-investment as savings are kept in the form of liquidity.

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THE IS-LM MODEL

The IS-LM model has become the standard model in macroeconomics.

Its essential contribution (linked to that of Keynes) is this potential equilibrium

unemployment:

y Such a situation is impossible in earlier neoclassic models, as the price of

labour (like all prices) is assumed to adjust naturally until supply and

demand for labour are balanced.

This is why IS-LM (1937!!) remains central to modern macroeconomics, and has

been extended to explain more markets/ variables:

y The AS-AD model adds inflation into the problem

y The Mundell-Fleming model deals with international trade

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THE IS CURVE

The IS curve shows all the combinations of

interest rates iand outputs Yfor which the

goods market is in equilibrium

y It is based on the goods market equilibrium we haveexamined in the first two weeks

However, a simplifying assumption we made

initially was that investment I was exogenousy We know that investment actually depends

negatively on the level of interest

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THE IS CURVE

The Investment functiony Is the sum of private investment (endogenous) and public

investment (exogenous)

y Here, the interest rate has a real interpretation: it is the

marginal profitability of investmentIg

i

g I I i G T

!

Ig= I(i) + (G-T)

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THE IS CURVE

The Savings function

y Is obtained from the aggregate demand equation,

subtracting investment and consumption:

S=Y-C-TS= -C

0+(1-c)(Y-T)

S

Y

S= -C0+ (1 - c)(Y-T)

mps: 0< (1-c)

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THE IS CURVE

i

i i

Y

Ig S

i Y

45 IS

S= -C0+ (1 - c)(Y-T)

Ig= I(i) + (G-T)

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THE IS CURVE

i

i i

Y

Ig S

i Y

45 IS

IS

Reduction in public

spending

IS shifts to the left

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THE IS CURVE

i

i i

Y

Ig S

i Y

45 ISIS

Higher propensity to

consume

IS flattens out

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THE LM CURVE

The LM curve shows all the combinations of interest rates iandoutputs Yfor which the money market is in equilibrium

y It is based on the money market equilibrium we have examined

last two weeks

This time the interest rate ihas a monetary interpretation:

y It is the opportunity cost of money, in other words the payment

made for renouncing liquidity (preference for liquidity)

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THE LM CURVE

Liquidity preference: Given a level of output Y, the level of

interest iadjusts so that the demand for money (given by the

liquidity function L) equals the exogenous supply:

M = Money supple (exogenous)

P = Level of prices (exogenous by assumption)

! iYLP

M,

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THE LM CURVE

Simplifying assumption: The liquidity function, which gives the demand for real

money balances, can be decomposed depending on the type of demand

There are two motives for demanding real money balances:

y The transaction and precautionary motive L1(Y) : The money demanded in

order to be able to transact in the future (function of the level of output)

y The speculation motive L2(i) : The money demanded for purposes of

speculation (opportunity cost of the interest rate). When interest is high,people dont want to hold money, whereas when the rates are low, money

demanded increases.

! iLYLiYL 21,

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THE LM CURVE

L1(Y)

Real Money Balances demanded for the

transaction and precautionary motive

(L1) are an increasing function of output

Y

Y

L1(Y)

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THE LM CURVE

i

Real Money Balances demanded for the

speculation motive (L2) are a decreasing

function of the rate of interest.

Under a given (low) level of interest, themoney demanded becomes infinite: agents

do not want to hold assets, and any money

available is hoarded.

Liquidity Trap

L2(i)

L2(i)

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THE LM CURVE

L1

Money supply M is fixed and exgogenous. The

money market equilibrium requires that the sum

of money demands add up to the supply of

money

(M/P) = L1(Y) + L2(i)

L2

Given one demand for money, say L2(i), then the

other is given, by:

L1(Y) = (M/P) - L2(i)

(M/P) = L1(Y) + L2(i)

45

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THE LM CURVEi i

Y

Y

L1(Y) L1(Y)

L2(Y)

L2(Y)

LM

45

L1(Y)

L2(i)

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THE LM CURVE

i i

Y

Y

L1(Y) L1(Y)

L2(Y)

L2(Y)

LM

LM

4545

Fall in money

supply

Pushes LM left

L1(Y)

L2(i)

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