AIOU Code 811 Monetary Theory and Policy Solved Notes Slides In English.pdf

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Course: Monetary Theory and Policy (811)
Q.1 Discuss in detail the various motives of money demand.
Economists define money via four of its basic functions. These functions will help us understand the importance
and need of money as far as the economy is concerned.
Unit of Account
Say you went to a shop and started browsing around. You see the price of the products on display. They are all
expressed in terms of money (rupees in this case). The cake is a hundred rupee, the pencil is ten rupees, the
sneakers are a thousand rupees and so on. So as you can see, money is the basic unit of account
or measurement of everything in an economy.
It is very important to have a uniform unit of account in an economy. The barter system does not work in all
cases. So it is highly efficient and convenient to have a uniform base for all transactions, i.e. money. It is the
foundation of every economic transaction happening anywhere around the world.
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Money means liquidity, i.e. it is the most liquid asset. It is the most convenient way to store wealth since you
can use to buy any goods or products directly. It requires no conversion. This is what we call the store value of
money.
If one was to store their wealth in other commodities, like gold or shares, there is a risk. These commodities do
not have a stable value. However, money does not fluctuate in value, it’s value/worth remains stable. This is
one of the biggest advantages of storing the value in money or currency.
Money is the most liquid asset in the world. We can exchange it for any commodity or service and so people
prefer to hold on to their cash. But then there is also the opportunity cost of money. Instead of preferring
liquidity if the money was invested it would earn interest. And so the demand for money is the balance between
these two motives.
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Transaction Motive
Money is a medium of exchange and this function of it’s gives rise to the transactional motive for demand for
money. We regularly need money to pay for goods and services. And such financial transactions can be of two
types – income motive and business motive.
The income motive is to bridge the gap between the receipt of the income and its eventual disbursement. And
the business motive is to bridge the gap between the time when costs are incurred and the time when you
receive the sale proceeds. If these time gaps are smaller, the person will hold less cash for his transactions and
vice versa.
There may be other factors involved for the changes in transactional demand for money like the expectation of
income, interest rate, business turnover etc. And from the above factors, we conclude that transactional demand
for money is a directly proportional function to the level of income. We express this as
L1 = kY
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Where L1 is transactional demand for money, k is the proportion of income kept for transactions and Y is
income.
Speculative Motive
The other important function of money is that it is a store value of wealth, i.e. it is an asset. And the demand
for any given asset depends on its opportunity cost and its rate of return. Now money does not have a rate of
return but it has an opportunity cost. The opportunity cost of holding money is the interest it could earn by
being invested in some bond.
The speculative motive for demand for money arises when investing the money in some asset or bond is
considered riskier than simply holding the money. The speculative motive for demand for money is also
affected by the expected rise or fall of the future interest rates and inflation of the economy.
If interest rates are expected to raise the opportunity cost of simply holding the money will also rise and reduce
the speculative motive. And if inflation is expected to rise, money will lose its purchasing power and again
speculative income will drop.
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Precautionary Motive:
It refers to the desire of people to hold cash balances for unforeseen contingencies. People wish to hold some
money to provide for the risk of unforeseen events like sickness, accident, etc. The amount of money held
under this motive, depends on the nature of individual and on the conditions in which he lives. The demand
of money for precautionary balances is also closely related to the level of income. Higher the level of income,
more will be the cash balances for contingencies. Under precautionary motive, cash is kept to meet
unforeseen transactions.
Q.2 Discuss in detail the different methods to measure the money supply.
he money supply is the total amount of money—cash, coins, and balances in bank accounts—in circulation.
The money supply is commonly defined to be a group of safe assets that households and businesses can use
to make payments or to hold as short-term investments. For example, U.S. currency and balances held in
checking accounts and savings accounts are included in many measures of the money supply.
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The money supply is the total quantity of money in the economy at any given time. Economists measure the
money supply because it is directly connected to the activity taking place all around us in the economy. In
addition, the Federal Reserve's Board of Governors and the Federal Open Market Committee use this
information as the basis of their monetary policy.
While most people think that money supply is one big pile of cash in the economy, economists look at it very
specifically. We can define the money supply in three different ways - M1, M2 and M3.
M1 is the narrowest definition of money. M1 consists of coins and currency in circulation, checking accounts,
small savings accounts, and traveler's checks.
M2 is a more broad definition of money than M1. M2 = M1 + money market funds and small time deposits.
M3 is even more broad and includes M2 + large time deposits, large money market funds and repurchase
agreements, which are financial instruments generally used by large businesses and institutions. Since 2006,
the Federal Reserve stopped using M3 - so now we have M1 and M2.
These measures correspond to three definitions of money that the Federal Reserve uses.
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Here's a snapshot of the money supply at the end of July 2012. As you can see, M1 consists of around $1
trillion in currency, about $4 billion in traveler's checks and another $1.26 trillion in demand deposits at
banks. These three make up M1, which totaled about $2.3 trillion. M2 takes M1 and adds several other things
to it. When you add savings accounts, small time deposits and small money market funds, you get a total of
about $10 trillion, which economists refer to as M2.
Methods used to measure the money supply include: M0, M1, and M2 and they have their corresponding
formulas.
M0, also denoted as MB, is the monetary base. It is calculated as:
M1 consists of money that can be spent immediately, and is the most liquid form of money:
M2 consists of M1 plus near-moneys that can be converted to cash quickly if needed. It also includes money
market funds (mutual funds that invest only in liquid assets):
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Not knowing the current money supply places the economy at risk of inflation (too much money) or recession
(too little money). That is why policymakers and bankers want to ensure sufficient liquidity in the market to
cover the demand for funds.
Knowing the current money supply lets the government adjust it through monetary policy. If the money
supply is too low to sustain healthy growth, which puts the economy at risk of a recession, the Fed can use
monetary policy to increase it. Conversely, if the money supply is too high, then to limit inflation, the Fed
can use monetary policy to decrease the money supply. However, the Fed would not be able to choose the
right policy if data on the amount of money circulating in the U.S. economy did not exist.
Based on the reserve ratio, which is the per cent of deposits that banks must keep in the form of cash,
policymakers can determine how much the money supply could increase if all excess reserves (deposits that
can be loaned, as opposed to required reserves, which must be kept in the form of cash) were loaned. Thus,
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the current money supply reveals how much spending could occur immediately and how much could occur
if all near-monies were loaned at the maximum allowable extent (until excess reserves were zero).
At the time of writing this article, the M2 money supply in the U.S. has reached high levels. This was also
associated with an increase in inflation in the U.S., reaching 8.5%, the highest since 1981.2
The data on the
money supply, which is available due to different methods of money supply measurement, helps the U.S
government and the Fed navigate the economy further by coming up with policies that address inflation
without significantly harming the economic growth of the U.S.
Accurately measuring the money supply can be difficult, as money exists in physical and electronic forms.
Additionally, the type of financial assets has evolved, and new financial products are being developed every
day.
Due to the ability of banks to lend money from deposits, one challenge of measuring the money supply is the
risk of double counting or counting the same value more than once. To prevent such accounting errors, banks
use balance sheets. Ensuring that all new deposits and loans are accounted for as both liabilities (something
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that is owed) and assets (something that is owned) makes it unlikely that banks will accidentally lend too
much. Banks are regulated and audited (have their records checked) by both state and federal agencies,
including the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC).
Another challenge in measuring the money supply is the prevalence of assets and securities (investments like
stocks and bonds) similar to money but are not legal tender (accepted by law as payment). U.S. Treasury
bonds may seem similar to cash but are not part of the money supply. Similarly, shares of stock, even though
they may be quickly bought and sold electronically, are not part of the money supply. Other investments like
gold and cryptocurrency, though they may look like money and even be used to buy goods and services, are
not technically money. Gold and silver bullion coins, often sold as one pure ounce, may resemble U.S.
currency but are not legal tender if the U.S. Mint does not mint them. Similarly, cryptocurrencies like Bitcoin
and Ethereum are not actual U.S. currencies. All of this makes it harder to measure the actual money supply
in the economy.
Q.3 Discuss in detail the Keynes theory of rate of interest.
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Keynesian economics is a macroeconomic economic theory of total spending in the economy and its effects
on output, employment, and inflation. Keynesian economics was developed by the British economist John
Maynard Keynes during the 1930s in an attempt to understand the Great Depression. Keynesian economics
is considered a "demand-side" theory that focuses on changes in the economy over the short run. Keynes’s
theory was the first to sharply separate the study of economic behavior and markets based on individual
incentives from the study of broad national economic aggregate variables and constructs.
Based on his theory, Keynes advocated for increased government expenditures and lower taxes to stimulate
demand and pull the global economy out of the depression. Subsequently, Keynesian economics was used
to refer to the concept that optimal economic performance could be achieved—and
economic slumps prevented by influencing aggregate demand through activist stabilization and economic
intervention policies by the government.
Keynesian economics represented a new way of looking at spending, output, and inflation. Previously, what
Keynes dubbed classical economic thinking held that cyclical swings in employment and economic output
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create profit opportunities that individuals and entrepreneurs would have an incentive to pursue, and in so
doing correct the imbalances in the economy. According to Keynes’s construction of this so-called classical
theory, if aggregate demand in the economy fell, the resulting weakness in production and jobs would
precipitate a decline in prices and wages. A lower level of inflation and wages would induce employers to
make capital investments and employ more people, stimulating employment and restoring economic growth.
Keynes believed that the depth and persistence of the Great Depression, however, severely tested this
hypothesis.
n Keynes’ theory changes in the supply of money affect all other variables through changes in the rate of
interest, and not directly as in the Quantity Theory of Money. The rate of interest, according to Keynes, is a
purely monetary phenomenon, a reward for parting with liquidity, which is determined in the money market
by the demand and supply of money.
This is in sharp contrast to the classical theory in which the rate of interest is made a real phenomenon, which
is determined in the commodity market by savings and investment at a level which equates the two. It is also
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in contrast to the loanable-funds theory which is essentially a reformulation of the savings-investment theory
of the rate of interest to take note of the phenomenon of hoarding or dis-hoarding and autonomous changes
in the stock of money. To understand Keynes’ theory, we go to his analysis of the money market.
Alongside the empirical account, the CEA find theoretical justification for their 30-year decline (and to aid
looking forward) in a host of the usual ‘real’, factors:
• lower long-run growth in output and productivity;
• the global saving glut (in part driven by lower productivity growth);
• shortage of safe assets, like U.S. Treasuries; and
• lower population growth.
(On a shorter horizon they emphasise post-crisis expansionary policy, low inflation and deleveraging of
private debt.)
Absolutely fundamental to Keynes’s view was that the long-term rate of interest was in the gift of
policymakers. This realisation dawned as he completed the drafting of his Treatise on Money in 1930. “The
root causes of what has happened is to be found in the high level of the market-rate of interest” (CW VI, p
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377). Only two years later he had devised the theory of liquidity preference. Keynes saw that the long-term
rate of interest was not a reward for saving, but the reward for parting with the liquidity of savings (or
wealth), after the decision to save (or rather not to consume) had been made. This reward was a psychological
factor, to some extent a matter of convention, and convention could be changed.
Over the 1930s and especially in World War Two, he devised increasingly sophisticated debt management
and monetary mechanisms that brought the whole spectrum of interest rates under the authorities’ control.
The reduction in the UK rate of interest over the 1930s was a result of these deliberate actions and advice.
Likewise, Roosevelt too took his cue from Keynes. Fundamentally, policy towards the monetary system was
brought under public rather than private authority, under the control of democratic forces rather than ‘vested
interests’.
The total demand for money (DM) is the sum of all three types of demand for money. That is,
Dm = Tdm + Pdm + Sdm
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The demand for money has a negative slope because of the inverse relationship between the speculative
demand for money and the rate of interest.
However, the negative sloping liquidity preference curve becomes perfectly elastic at a low rate of interest.
According to Keynes, there is a floor interest rate below which the rate of interest cannot fall. This minimum
rate of interest indicates absolute liquidity preference of the people.
Q.4 Explain the concept of money neutrality?
Money neutrality is a concept of monetary economics for which an increase in the supply of money affects
only prices, without impacting the real economy.
As in any free market, supply and demand will meet each other at an equilibrium point at a certain price. For
money, the price corresponds to the interest rate paid on the money borrowed. It means that:
• Given the money supply as a constant, the demand for money is a function of the interest rate charged.
• If the interest rate rises, the speculative demand for money falls.
• If the interest rate falls, the speculative demand for money rises.
• For any level of money supply, there is a level of interest rate for which no excess demand or supply exists.
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The equilibrium point is usually referred to as the Equilibrium Interest Rate.
Actions of Economic Agents
• If the interest rate is above the equilibrium point, there is an excess supply of money. As a result, economic agents
use the liquidity to buy bonds, pushing up their price until the interest rate is back to the equilibrium rate of
interest.
• If the interest rate is below the equilibrium point, there is an excess demand for money. As a result, economic
agents sell bonds, pushing down their prices until the interest rate is back to the equilibrium rate of interest.
Effects of an Excess Supply of Cash
As in any market, when the supply of a good rises more than demand, such good becomes less valuable, and
its price declines. Similarly, when the supply of money increases, its price (the interest rate) declines.
While the theoretical models help, the effects of interest rates and monetary policy are not so simple.
When there is an increase in money supply, there is an excess supply of cash for businesses and people that
they can use in several ways, such as:
• They can lend it to other businesses and individuals;
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• They can use it for buying financial assets, such as bonds; and/or
• They can use it for buying real assets, goods, and services.
Some economists support the concept of money neutrality, while others disagree. In general, it can be agreed
that policymakers don’t believe that changes in the money supply do not affect the real economy. If they did,
monetary policy measures, such as cutting or raising interest rates, or quantitative easing/tightening, cannot
be explained.
Policymakers generally believe that, at least in the short term, an increase (decrease) in money will result in
a positive (negative) effect on economic activity. While many economists defend money neutrality in the
long term, the effects of money supply on the economy in the short term are difficult to ignore. For example,
the excess liquidity created in the short term can exert an impact on the inflation rate. With inflation rising,
holding money becomes less attractive than holding real assets. As a consequence:
• People will allocate their resources away from cash and into durable goods or even increase their consumption of
non-durable goods. It will obviously lead to an increase in consumption and GDP and a decrease in inventory levels.
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• Companies will allocate more resources into real assets, potentially increasing their productive capacity and actual
production levels. As a result, industrial production and GDP growth will increase.
The neutrality of money theory has attracted criticism from some quarters. Many notable economists reject
the concept in the short and long run, including John Maynard Keynes, Ludwig von Mises, and Paul
Davidson. The post-Keynesian school and Austrian school of economics also dismiss it.
Several econometric studies suggest that variations in the money supply affect relative prices over long
periods of time.
The primary argument states that as the money supply increases, the value of money decreases. Eventually,
as the increased supply of money spreads throughout the economy, the prices of goods and services will
increase in order to reach a point of equilibrium by counteracting the increase of the money supply.
Critics also argue that an increase in the supply of money impacts consumption and production. Because an
increase in the supply of money increases prices, this increase in price alters how individuals and businesses
interact with the economy.
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Q.5 Discuss in detail the role of money in Classical System.
The fundamental principle of the classical theory is that the economy is self‐regulating. Classical economists maintain
that the economy is always capable of achieving the natural level of real GDP or output, which is the level of real GDP
that is obtained when the economy's resources are fully employed. While circumstances arise from time to time that
cause the economy to fall below or to exceed the natural level of real GDP, self‐adjustment mechanisms exist within
the market system that work to bring the economy back to the natural level of real GDP. The classical doctrine—that
the economy is always at or near the natural level of real GDP—is based on two firmly held beliefs: Say's Law and the
belief that prices, wages, and interest rates are flexible.
Say's Law. According to Say's Law, when an economy produces a certain level of real GDP, it also
generates the income needed to purchase that level of real GDP. In other words, the economy is always
capable of demanding all of the output that its workers and firms choose to produce. Hence, the economy is
always capable of achieving the natural level of real GDP.
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The achievement of the natural level of real GDP is not as simple as Say's Law would seem to suggest. While
it is true that the income obtained from producing a certain level of real GDP must be sufficient to purchase
that level of real GDP, there is no guarantee that all of this income will be spent. Some of this income will
be saved. Income that is saved is not used to purchase consumption goods and services, implying that the
demand for these goods and services will be less than the supply. If aggregate demand falls below aggregate
supply due to aggregate saving, suppliers will cut back on their production and reduce the number of
resources that they employ. When employment of the economy's resources falls below the full employment
level, the equilibrium level of real GDP also falls below its natural level. Consequently, the economy may
not achieve the natural level of real GDP if there is aggregate saving. The classical theorists' response is that
the funds from aggregate saving are eventually borrowed and turned into investment expenditures,
which are a component of real GDP. Hence, aggregate saving need not lead to a reduction in real GDP. In
the classical system, money is neutral in its effects on the economy. It plays no role in the determination of
employment, income and output. Rather, they are determined by labour, capital stock, state of technology,
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availability of natural resources, saving habits of the people, and so on. In the classical system, the main
function of money is to act as a medium of exchange.
It is to determine the general level of prices at which goods and services will be exchanged. The quantity
theory of money states that the price level is a function of the supply of money. Algebraically, MV=PT,
where, M, V, P and T are the supply of money, velocity of money, price level, and the volume of transactions
(or total output) respectively.
The equation tells that the total money supply, MV, equals the total value of output, PT, in the economy.
Assuming V and T to be constant, a change in M causes a proportionate change in P. Thus money is neutral.
It is simply a ‘veil’ whose main function is to determine the general price level at which goods and services
exchange.
The notion of neutrality of money in the classical system is explained in terms of Fig. 1. Where we start with
an initial full employment equilibrium position with No, Qoâ€™ W/Poâ€™ Moâ€™ Po, and Woâ€™ as illustrated in
Panels (A), (B), (C) and (D) of Fig. 1. The initial equilibrium is disturbed when the quantity of money is
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increased from M0 to M1. This leads to a rise in effective demand from MV0 to MV1, and shown in Panel
(C).
This raises commodity prices in proportion to the rise in M, since real output O is fixed. In other words, the
rise in the price level is exactly proportional to the rise in the quantity of money, i.e. P0 P1=M0 M1. With
increase in the price level, the money wage rate will rise as rapidly as prices to (Panel D) in order to keep the
real wage rate W/Po unchanged (Panel B). But with increase in the price level, the real wage rate tends to
decrease from W/Pp to W/P1, as shown in Panel B of the figure.
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This increases the demand for labour by more than the supply of labour which is shown by the distance sd in
Panel B. The competitive bidding for labour will ultimately lead to rise in the real wage rate to W/P0 whereby
the labour market equilibrium is restored at point E. Thus the result of an increase in money is to raise money
wages and prices in equal proportion, leaving output, employment and the real wage rate unaffected. It is in
this sense that money is a veil or neutral in the classical system. An increase in savings will lead to an increase
in investment expenditures through a reduction of the interest rate, and the economy will always return to the
natural level of real GDP. The flexibility of the interest rate as well as other prices is the self‐adjusting
mechanism of the classical theory that ensures that real GDP is always at its natural level. The flexibility of
the interest rate keeps the money market, or the market for loanable funds, in equilibrium all the
time and thus prevents real GDP from falling below its natural level. Similarly, flexibility of the wage rate
keeps the labor market, or the market for workers, in equilibrium all the time. If the supply of workers
exceeds firms' demand for workers, then wages paid to workers will fall so as to ensure that the work force
is fully employed. Classical economists believe that any unemployment that occurs in the labor market or in
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other resource markets should be considered voluntary unemployment. Voluntarily unemployed
workers are unemployed because they refuse to accept lower wages. If they would only accept lower wages,
firms would be eager to employ them.
ASSIGNMENT No. 2
Q.1Explain in detail the features of neo-Classical synthesis.
The Neo-classical synthesis (also referred to as the neo-Keynesian theory) refers to the post-war
macroeconomic development which combined elements of Keynesian macroeconomics with more classical
microeconomic theory. (This is not relevant for A-Level economics; you may be relieved to know)
Up until the 1930s, economics had been dominated by classical economists who argued that markets were
self-regulating, markets would clear and markets were the most efficient method of distributing resources.
Keynesian theory, however, suggested markets weren’t self-regulating and could be below full employment
for a considerable time.
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The neo-classical synthesis suggests that Keynes was right in the short term, and classical economists were
correct in the long-term. Markets may be subject to short-term shocks which put them out of equilibrium.
But, in the long-term, free markets were best for distributing resources. The neo-classical synthesis suggests
government intervention should primarily be concentrated on the short-term, stimulating demand in a
recession, and dealing with rigidities in labour markets, such as monopolies, minimum wages and
monopsonies. One of the key early assumptions of neoclassical economics is that utility to consumers, not
the cost of production, is the most important factor in determining the value of a product or service.
Neoclassical economics theories underlie modern-day economics, along with the tenets of Keynesian
economics. Although the neoclassical approach is the most widely taught theory of economics, it has its
detractors.
Further, neoclassical economics stipulates that a product or service often has value above and beyond its
production costs. While classical economic theory assumes that a product's value derives from the cost of
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materials plus the cost of labor, neoclassical economists say that consumer perceptions of the value of a
product affect its price and demand.
Finally, this economic theory states that competition leads to an efficient allocation of resources within an
economy. The forces of supply and demand create market equilibrium.
In contrast to Keynesian economics, the neoclassical school states that savings determine investment. It
concludes that equilibrium in the market and growth at full employment should be the primary economic
priorities of government.
Key people in the Neo-Classical Synthesis
• John Hicks. Hicks developed the IS/LM model in 1937, which is based on Keynesian macroeconomic insights.
• Paul Samuelson. In the post-war period, Samuelson was one of the first economists to popularise Keynesian theory
with his amendments. His textbook, Economics: An Introductory Analysis, first published in 1948 was instrumental
in sharing Keynesian macroeconomic principles, alongside more classical microeconomic theory.
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Politics of the Neo-Classical Synthesis
There was a belief Keynesian economics was partly inspired by ‘Communist’ ideas. This was in the
‘McCarthyism era’ with great suspicion of any ‘left wing’ ideas. Samuelson’s synthesis helped to dilute
Keynesian economics to give it more market-based approach and this became the more widespread version
of Keynesian economics.
Key Elements of the Neoclassical Synthesis
Government intervention could help the economy be maintained close to full employment. For example, in
an economic downturn, the government could pursue expansionary fiscal policy to boost demand. In the
1950s and 1960s, these ideas received widespread support as most major economies experienced two decades
of economic expansion and close to full employment. Richard Nixon said in the early 1970s ‘we’re all
Keynesians now‘
Monetary and Fiscal Policy. Keynes had concentrated on the role of fiscal policy in managing the economy.
However, the neo-Keynesians became more accepting that Monetary policy could also be used to manage
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demand and the rate of economic growth. By the late 1990s, the neo-classical synthesis had embraced the
role of monetary policy in achieving inflation targets. (neoclassical synthesis and monetary policy)
In the post-war period, the Phillips curve was considered a significant aspect of economic policy. It appeared
there was a trade-off between inflation and unemployment and the government could decide which to
prioritise.
Neo-Keynesian acceptance of Neo-classical micro ideas
Keynes had rejected many of the classical microeconomic theories, such as ergodic axion, neutral money and
gross substitution. The Neo-classical synthesis reverted to the classical view of these microeconomic
foundations.
1. Ergodic axiom. Keynes argued the future wasn’t pre-determined, there were many unknown variables. The neo-
classical synthesis rejected this and supported the ergodic axiom of neo-classical economics. What this means is
the neo-classical synthesis argued the future could be determined by market fundamentals (a kind of efficient
market hypothesis). Keynes said it couldn’t, Keynes placed a greater role in people’s behaviour, ‘animal spirits’ and
actions influencing the future.
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2. Neutral Money. Neo-Keynesians believed money was neutral (money supply didn’t affect real output). Keynes
rejected neutrality of money in the short and long-term.
3. Gross substitution. Classical economics argues money is a close substitute for less liquid assets. Keynes argued
they are not close substitutes. If people save more money in liquid assets, there will be a fall in demand for physical
goods. Therefore, Say’s law is broken (supply = demand). The lack of substitution explains why markets often fail
to clear. The neo-classical synthesis accepted the classical version of gross substitution.
Bastard Keynesianism
English economist Joan Robinson labelled these ‘neo-Keynesian ideas’ as Keynesianism because they
rejected many key elements of Keynes’ theory.
Breakdown of Neo-Classical Synthesis.
In the early 1970s, stagflation caused neo-Keynesian ideas to fall out of place. The theory struggled to explain
rising inflation and unemployment at the same time.
Q.2Discuss in detail the role of money according to Friedman.
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Building on the work of earlier scholars, including Irving Fisher of Fisher Equation fame, Milton Friedman
improved on Keynes’s liquidity preference theory by treating money like any other asset. He concluded that
economic agents (individuals, firms, governments) want to hold a certain quantity of real, as opposed to
nominal, money balances. If inflation erodes the purchasing power of the unit of account, economic agents
will want to hold higher nominal balances to compensate, to keep their real money balances constant. The
level of those real balances, Friedman argued, was a function of permanent income (the present discounted
value of all expected future income), the relative expected return on bonds and stocks versus money, and
expected inflation.
More formally,
M d / P : f ( Y p <+> , r b − r m <−> , r s − r m <−> , π e − r m <−> )
where
Md/P = demand for real money balances (Md = money demand; P = price level)
f means “function of” (not equal to)
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Yp = permanent income
rb − rm = the expected return on bonds minus the expected return on money
rs − rm = the expected return on stocks (equities) minus the expected return on money
πe
− rm = expected inflation minus the expected return on money
<+> = increases in
<−> = decreases in
First of all Friedman says that his quantity theory is a theory of demand for money and not a theory of output,
income or prices. Secondly, Friedman distinguishes between two types of demand for money. In the first
type, money is demanded for transaction purposes. It serves as a medium of exchange. This view of money
is the same as the old quantity theory. But in the second type, money is demanded because it is considered
as an asset. Money is more basic than the medium of exchange. It is a temporary abode of purchasing power
and hence an asset or a part of wealth. Friedman treats the demand for money as a part of the wealth theory.
Thirdly, Friedman treats the demand for money just like the demand for any durable consumer good.
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The demand for money depends on three factors:
(a) The total wealth to be held in various forms
(b) The price or return from these various assets and
(c) Tastes and preferences of the asset holders.
Friedman considers five different forms in which wealth can be held, namely, money (M), bonds (B), equities
(E), physical non-human goods (G) and human capital (H). In a broad sense, total wealth consists of all types
of “income”. By “income” Friedman means “aggregate nominal permanent income” which is the average
expected yield from wealth during its life time.
The wealth holders distribute their total wealth among its various forms so as to maximise utility from them.
They distribute the assets in such a way that the rate at which they can substitute one form of wealth for
another is equal to the rate at which they are willing to do.
Accordingly the cost of holding various assets except human capital can be measured by the rate of interest
on various assets and the expected change in their prices. Thus Friedman says there are four factors which
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determine the demand for money. They are: price level, real income, rate of interest and rate of increase in
the price level.
The demand for money is unitarily elastic. The relationship between the demand for money and real income
(output of goods and services) is also direct. But it is not proportional as in the case of price. Thus while
changes in the price level cause direct and proportional changes in the demand for money, changes in real
income create direct but more than proportional changes in the demand for money.
The rate of interest and the rate of increase in the price level constitute the cost of holding cash balances. If
money is kept in the form of cash, it does not earn any income. But if the same money is lent out, it could
earn some income in the form of interest to the owner.
The interest is the cost of holding cash. At higher interest rate the demand for money would be less. On the
other hand, a lower rate of interest creates an increase in the demand for money. Thus there is an inverse
relationship between the rate of interest and the demand for money.
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The rate of increase in the price level also influences the demand for money. There is an inverse relationship
between the rate of increase in the price level and the demand for money. When the price level increases at
a high rate, the cost of holding money will increase.
The people would like to hold smaller cash balances. The demand for money will decline. On the other hand
when the price level increases at a low rate, the cost of holding money will decline and the demand for money
increases.
Fourthly, Friedman believes that each form of wealth has its own characteristics and a different yield or
return. In a broad sense money includes currency, demand deposits and time deposits which yield interest.
Money also yields real return in the form of convenience, security etc., to the holder which is measured in
terms of price (P). When the price level falls, the rate of return on money is positive because the value of
money increases. When the price level rises, the value of money falls and the rate of return is negative. Thus
P is an important variable in the demand function of Friedman.
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The rate of return on bonds, equities and physical assets consists of currently paid interest rate and changes
in their prices. As far as human wealth is concerned it is very difficult to measure the conversion of human
into non-human wealth due to institutional constraints. But there is some possibility of substituting human
wealth for non-human wealth.
Freidman calls the ratio of non-human wealth to human wealth or ratio of wealth to income as W. According
to Friedman, income elasticity of demand for money is greater than unity. Besides, there are certain variables
like the tastes and preferences of the wealth holders which also affect the demand functions. These variables
are represented by m.
Q.3Inflation is a monetary phenomenon. Discuss.
“Inflation is always and everywhere a monetary phenomenon.” Monetary economist Milton Friedman made
this line famous after stating it in a talk he gave in India in 1963. In a trivial sense, of course, the statement
is true. Inflation, by definition, means that money loses its purchasing power and, therefore, is a monetary
phenomenon. But Friedman meant much more. After having defined inflation, in that same talk, as a “steady
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and sustained rise in prices,” Friedman argued that one could not find inflation anywhere in the world that
was not caused by a prior increase in the supply of money or in the growth rate of the supply of money. His
statement was an empirical one, not a logically necessary one, and most professional economists, still in the
thrall of John Maynard Keynes, did not agree with Friedman. But within a decade, the evidence from the
United States and other countries had convinced most economists that Friedman was right.
The reason has to do with what is called variously the quantity equation or the equation of exchange: MV =
Py. In that equation, M is the supply of money, V is the velocity of money (which is inversely related to the
demand for money), P is the price level, typically measured by the CPI, and y is real gross domestic product.
Incidentally, Milton Friedman had a version of that equation on his California license plate.
Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced
only by a more rapid increase in the quantity of money than in output.
This claim that inflation is a monetary phenomenon is based on the quantity theory of money, according to
which prices vary in proportion to the money supply. This relationship is based on a mathematical
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identity,1 according to which the value of transactions carried out in an economy (understood as nominal
GDP) is equivalent to the amount of money circulating in that economy (understood as the amount of money
in an economy multiplied by the number of times this changes hands; i.e. the velocity of money). If we
assume that the velocity of money is constant, in an economy without economic growth the inflation rate
equals the rate of growth in money. Therefore, if money supply increases, there will be more money chasing
the same goods, so prices will go up. Similarly, if the rate of growth for economic activity and the quantity
of money is the same, prices should remain constant.
Friedman's statement has been backed by empirical evidence, also showing a positive relationship between
inflation and growth in excess money supply (growth in money supply above the real growth in GDP) for a
large number of countries. This relationship is strong and robust in the long term but, the relationship between
both variables may weaken temporarily in the short term due to factors such as price rigidity and the velocity
of money not being constant. For example, a reduction in the velocity of money in circulation would be
compatible with an increase in the money supply without putting pressure on prices.
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Based on the above, both the theory and empirical evidence suggest that, if growth in the money supply is
greater than the actual growth in GDP, this should push up inflation in the medium term. However, since the
start of 2012, the relationship between both variables seems to have weakened to the point of almost
disappearing. On the one hand, growth in money supply has accelerated more than GDP growth while, on
the other, core inflation2 has continued to fall. Below we look at the main factors that lie behind this
decoupling between monetary aggregates and prices in the last few years.
In this respect, an analysis of the effectiveness of monetary policy and specifically how it affects monetary
aggregates is essential. In general terms, when a central bank offers liquidity to the banking system, either
by offering long-term credit or by directly purchasing some of its assets, the monetary base increases.3 There
is no automatic rise in the money supply,4
however. Traditionally banks would use the liquidity provided by
central banks to increase the supply of credit5 and movements in money supply were therefore in line with
those in the monetary base, ultimately leading to an increase in consumption and investment and thereby
pushing up prices.
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However, the considerable increase in the monetary base occurring over the last few years has not led to a
similar increase in the money supply (see the table). The factors limiting the growth capacity for credit can
be found both in its demand and supply. Specifically, a significant part of demand was immersed in an
extensive deleveraging process. Moreover, the healthier part of the private sector did not demand credit
either, afflicted by a highly uncertain environment that encouraged them to save and postpone decisions to
consume and invest. On the supply side, the adjustments banks have had to carry out in order to comply with
the new banking regulations (Basel III), both in terms of solvency with higher capital ratios and also in terms
of liquidity, have encouraged them to be very cautious when granting loans and to hold onto a considerable
buffer of liquidity.
Given this scenario, many banks have opted to use the liquidity they have received to increase their reserves
with the central bank and thereby maintain some room to manoeuvre to handle any upswings in financial
tension or further regulatory requirements. With the remaining liquidity, investors looked for a more
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attractive return-risk combination, either in other financial assets or in other economies that were growing.
A lot of the liquidity provided by central banks has therefore ended up in the main emerging economies.
One last factor that should be taken into account is the growing importance of alternative sources of financing
to deposits in the pre-crisis period.6 Traditionally, when financial brokerage was mainly through banks, their
liabilities, in other words traditional monetary aggregates, were a good indicator of the quantity of money in
the economy. However, this relationship has weakened with the expansion of the wholesale funding market.
For example, in the US, when commercial banks used to sell asset-backed securities, they could lend again
with the liquidity obtained. For their part, the vehicles set up to buy asset-backed securities were financed by
issuing short-term financial debt (commercial paper), which is not included in monetary aggregates. In
practice, therefore, there was an increase in credit without any increase in monetary aggregates.
Another paradigmatic case with similar results is provided by temporary sales of securities, also known as
repurchase agreements or repos, used by banks to lend each other money using a security as a guarantee. As
in the case of securitisation, this practice became an important source of liquidity that helped to increase the
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supply of credit. Moreover, in the US repos are not included in the traditional measurement of money supply
either so that, also in this case, the resulting boost for credit did not lead to an increase in monetary aggregates.
As can be seen in the corresponding graph, during the years of strong growth the volume of financial
commercial paper and repos increased sharply but, after the crisis erupted, they plummeted and have yet to
recover. The traditional measures of money supply shown in the table above therefore underestimate the
liquidity available before the crisis and do not reflect its subsequent contraction. Although the expansion in
the monetary base by the central banks aimed to replace this lack of liquidity, it has not been enough and,
consequently, the pressure on prices is still low.
In short, although the relationship between prices and monetary aggregates seems to have dwindled this is
partly due to temporary factors such as those related to the supply and demand for credit. Therefore, as the
economic recovery takes hold, both are likely to synchronise again. It is more difficult to determine the role
played by the greater integration of global financial markets although, judging by the last few years, central
banks seem to find it very difficult to control the liquidity they inject as this is easily directed towards other
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economies. A lesson that should be borne in mind when evaluating the effectiveness of the measures recently
announced by the ECB.
Q.4Explain in detail different types of inflation.
Inflation is an economic indicator that indicates the rate of rising prices of goods and services in the economy.
Ultimately it shows the decrease in the buying power of the rupee. It is measured as a percentage.
This percentage indicates the increase or decrease from the previous period. Inflation can be a cause of
concern as the value of money keeps decreasing as inflation rises.
Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the
rate at which the decline in purchasing power occurs can be reflected in the increase of an average price
level of a basket of selected goods and services in an economy over some period of time. The rise in prices,
which is often expressed as a percentage, means that a unit of currency effectively buys less than it did in
prior periods. Inflation can be contrasted with deflation, which occurs when the purchasing power of money
increases and prices decline. While it is easy to measure the price changes of individual products over time,
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human needs extend beyond just one or two products. Individuals need a big and diversified set of products
as well as a host of services for living a comfortable life. They include commodities like food grains, metal,
fuel, utilities like electricity and transportation, and services like health care, entertainment, and labor.
Inflation aims to measure the overall impact of price changes for a diversified set of products and services,
and allows for a single value representation of the increase in the price level of goods and services in an
economy over a period of time.
An increase in the supply of money is the root of inflation, though this can play out through different
mechanisms in the economy. A country's money supply can be increased by the monetary authorities by:
• Printing and giving away more money to citizens
• Legally devaluing (reducing the value of) the legal tender currency
• Loaning new money into existence as reserve account credits through the banking system by purchasing
government bonds from banks on the secondary market (the most common method)
Inflation occurs when the prices of goods and services increase. There are four main types of inflation, categorized by
their speed. They are "creeping," "walking," "galloping," and "hyperinflation." There are specific types of asset inflation
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and also wage inflation. Some experts argue that demand-pull (also known as "price inflation") and cost-push inflation
are two more types, but they are causes of inflation. So is the expansion of the money supply.
Creeping Inflation
Creeping or mild inflation occurs when prices rise by 3% or less per year. According to the Federal Reserve,
when prices increase by 2% or less, it benefits economic growth. That kind of mild inflation makes consumers
expect that prices will keep going up, which boosts demand. Consumers buy now in order to beat higher
future prices. That's how mild inflation drives economic expansion. For that reason, the Fed sets 2% as its
target inflation rate.
Walking Inflation
This strong, or destructive, inflation is between 3% and 10% per year. It is harmful to the economy, because
it heats up economic growth too quickly. People start to buy more than they need, to avoid tomorrow's much-
higher prices. This increased buying drives demand even further so that suppliers can't keep up. More
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important, neither can wages. As a result, common goods and services are priced out of the reach of most
people.
Galloping Inflation
When inflation rises to 10% or more, it wreaks absolute havoc on the economy. Money loses value so quickly
that business and employee income can't keep up with costs and prices. Foreign investors, in turn, avoid the
country where this occurs, depriving it of needed capital. The economy becomes unstable, and government
leaders lose credibility. Galloping inflation must be prevented at all costs.
Hyperinflation
Hyperinflation occurs when prices skyrocket by more than 50% per month. It is very rare. In fact, most
examples of hyperinflation occur when governments print money to pay for wars. Examples of hyperinflation
include Germany in the 1920s, Zimbabwe in the 2000s, and Venezuela in the 2010s. The last time the United
States experienced hyperinflation was during the Civil War.
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Stagflation
Stagflation occurs when economic growth is stagnant but there still is price inflation.This combination seems
contradictory, if not impossible, though.
This phenomenon happened in the 1970s when the United States abandoned the gold standard. Once the
dollar's value was no longer tied to gold, it plummeted. At the same time, the price of gold skyrocketed.
Stagflation didn't end until Federal Reserve Chairman Paul Volcker raised the fed funds rate to the double-
digits. He kept it there long enough to dispel expectations of further inflation.
Core Inflation
The core inflation rate measures rising prices in everything except food and energy. That's because gas prices
tend to escalate every summer. Families use more gas to go on vacation. Higher gas costs increase the price
of food and anything else that has high transportation costs.
The Federal Reserve uses the core inflation rate to guide it in setting monetary policy. The Fed doesn't want
to adjust interest rates every time gas prices go up.
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Deflation
Deflation is the opposite of inflation. It's when prices fall. It's caused when an asset bubble bursts.
That's what happened in housing in 2006. Deflation in housing prices trapped those who bought their homes
in 2005. In fact, the Fed was worried about the overall deflation during the recession. That's because deflation
can turn a recession into a depression. During the Great Depression of 1929, prices dropped by 10% per year.
Wage Inflation
Wage inflation occurs when workers' pay rises more rapidly than the cost of living. It happens in three
situations. The first is when there is a shortage of workers. The second is when labor unions negotiate ever-
higher wages. The third is when workers effectively control their pay.10
A worker shortage occurs whenever unemployment is below 4%. Labor unions negotiated higher pay for
autoworkers in the 1990s.11
CEOs effectively control their pay by sitting on many corporate boards,
especially their own. All of these situations creat wage inflation.
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Of course, everyone thinks their own wage increases are justified, but higher wages are one element of cost-
push inflation. That can drive up the prices of a company's goods and services.
Asset Inflation
An asset bubble, or asset inflation, occurs in one asset class. Good examples include housing, oil, and gold.
It is often overlooked by the Federal Reserve and other inflation-watchers when the overall rate of inflation
is low. But the subprime mortgage crisis and subsequent global financial crisis demonstrated how damaging
unchecked asset inflation could be.
Asset Inflation—Gas
Gas prices rise each spring in anticipation of the summertime vacation driving season. In fact, you can expect
gas prices to rise ten cents per gallon each spring. But political uncertainty in the oil-exporting countries
drove gas prices higher in 2011 and 2012. Prices hit an all-time peak of $4.06 in July 2008, thanks to
economic uncertainty.
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What do oil prices have to do with gas prices? A lot. In fact, oil prices are responsible for about two-thirds
of gas prices. The rest is distribution and taxes. They aren't as volatile as oil prices.
Asset Inflation—Oil
Crude oil prices hit an all-time high of $145.31 a barrel in July 2008.14
This inflation-adjusted price was
despite a decrease in global demand and an increase in supply. Commodities traders determine oil prices.
Those traders include both speculators and corporate traders who are hedging their risks. Traders bid up crude
oil prices in two types of situations. The first is if they think there are threats to supply, such as unrest in the
Middle East. The second is if they see an uptick in demand, such as growth in China.
Asset Inflation—Food
Food prices soared 6.4% in 2008, causing food riots in India and other emerging markets. They spiked again
in 2011, rising by 4.8%.15
High food costs led to the Arab Spring, according to many economists. Food riots
caused by inflation in this important asset class could reoccur. As of January 2022, food prices have increased
by 7% in the United States, reflecting the highest food inflation we have seen in forty years.7
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Asset Inflation—Gold
An asset bubble occurred when gold prices hit the all-time high of $1,895 per ounce on September 5,
2011. Although many investors might not call this inflation, it sure was. That's because prices rose without a
corresponding shift in gold's supply or demand. Instead, investors ran to gold as a safe-haven. They were
concerned about the declining dollar. They felt gold protected them from hyperinflation in U.S. goods and
services. They were uncertain about global stability.
During the summer, the eurozone debt crisis looked like it might not get resolved. There was also stress about whether
the United States would default on its debt. Gold prices rise in response to uncertainty. Sometimes, it's to hedge against
inflation. Other times, it's the exact opposite, the resurgence of recession.
Q.5Write short notes on the following:
a) Law of one price
The law of one price is an economic concept that states that the price of an identical asset or commodity will
have the same price globally, regardless of location, when certain factors are considered.
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The law of one price takes into account a frictionless market, where there are no transaction costs,
transportation costs, or legal restrictions, the currency exchange rates are the same, and that there is no price
manipulation by buyers or sellers. The law of one price exists because differences between asset prices in
different locations would eventually be eliminated due to the arbitrage opportunity.
The arbitrage opportunity would be achieved whereby a trader would purchase the asset in the market it is
available at a lower price and then sell it in the market where it is available at a higher price. Over time,
market equilibrium forces would align the prices of the asset.
The law of one price is the foundation of purchasing power parity. Purchasing power parity states that the
value of two currencies is equal when a basket of identical goods is priced the same in both countries. It
ensures that buyers have the same purchasing power across global markets. In reality, purchasing power
parity is difficult to achieve, due to various costs in trading and the inability to access markets for some
individuals.
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The formula for purchasing power parity is useful in that it can be applied to compare prices across markets
that trade in different currencies. As exchange rates can shift frequently, the formula can be recalculated on
a regular basis to identify mispricings across various international markets.
If the price of any economic good or security is inconsistent in two different free markets after considering
the effects of currency exchange rates, then to earn a profit, an arbitrageur will purchase the asset in the
cheaper market and sell it in the market where prices are higher. When the law of one price holds, arbitrage
profits such as these will persist until the price converges across markets.
For example, if a particular security is available for $10 in Market A but is selling for the equivalent of $20
in Market B, investors could purchase the security in Market A and immediately sell it for $20 in Market B,
netting a profit of $10 without any true risk or shifting of the markets.
Violations of the Law of One Price
In the real world, the assumptions built into the law of one price frequently do not hold, and persistent
differentials in prices for many kinds of goods and assets can be readily observed.
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Transportation Costs
When dealing in commodities, or any physical good, the cost to transport them must be included, resulting
in different prices when commodities from two different locations are examined.
If the difference in transportation costs does not account for the difference in commodity prices between
regions, it can be a sign of a shortage or excess within a particular region. This applies to any good that must
be physically transported from one geographic location to another rather than just transferred in title from
one owner to another. It also applies to wages for any employment where the worker must be physically
present at the worksite to perform the job.
Transaction Costs
Because transaction costs exist and can vary across different markets and geographic regions, prices for the
same good can also vary between markets. Where transaction costs, such as the costs to find an appropriate
trading counterparty or costs to negotiate and enforce a contract, are higher, the price for a good will tend to
be higher there than in other markets with lower transaction costs.
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Legal Restrictions
Legal barriers to trade, such as tariffs, capital controls, or in the case of wages, immigration restrictions, can
lead to persistent price differentials rather than one price. These will have a similar effect to transportation
and transaction costs, and might even be thought of as a type of transaction cost. For example, if a country
imposes a tariff on the importation of rubber, then domestic rubber prices will tend to be higher than the
world price.
Market Structure
Because the number of buyers and sellers (and the ability of buyers and sellers to enter the market) can vary
between markets, market concentration and ability of buyers and sellers to set prices can vary as well.
b) Fixed and floating exchange rate system
A fixed exchange rate denotes a nominal exchange rate that is set firmly by the monetary authority with
respect to a foreign currency or a basket of foreign currencies. By contrast, a floating exchange rate is
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determined in foreign exchange markets depending on demand and supply, and it generally fluctuates
constantly.
A fixed exchange rate regime reduces the transaction costs implied by exchange rate uncertainty, which might
discourage international trade and investment, and provides a credible anchor for low-inflationary monetary
policy. On the other hand, autonomous monetary policy is lost in this regime, since the central bank must
keep intervening in the foreign exchange market to maintain the exchange rate at the officially set level.
Autonomous monetary policy is thus a big advantage of a floating exchange rate. If the domestic economy
slips into recession, it is autonomous monetary policy that enables the central bank to boost demand, thus
'smoothing" the business cycle, i.e. reducing the impact of economic shocks on domestic output and
employment. Both types of exchange rate regime have their pros and cons, and the choice of the right regime
may differ for different countries depending on their particular conditions. In practice there is a range of
exchange rate regimes lying between these two extreme variants, thus providing a certain compromise
between stability and flexibility.
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The exchange rate in the Czech Republic was pegged to a basket of currencies until early 1996, then the peg
was effectively eliminated through a substantial widening of the fluctuation band, and now the Czech
economy operates in the so-called managed floating regime, i.e. the exchange rate is floating, but the central
bank may turn to interventions should there be any extreme fluctuations.
Fixed exchange rates, floating exchange rates, and currency boards/unions, and outlines the advantages and
disadvantages of each. Floating exchange rate regimes are market determined; values fluctuate with market
conditions. In fixed exchange rate regimes, the central bank is dedicated to using monetary policy to maintain
the exchange rate at a predetermined price. In theory, under such an arrangement, a central bank would be
unable to use monetary policy to promote any other goal; in practice, there is limited leeway to pursue other
goals without disrupting the exchange rate. Currency boards and currency unions, or “hard pegs,” are extreme
examples of a fixed exchange rate regime where the central bank is truly stripped of all its capabilities other
than converting any amount of domestic currency to a foreign currency at a predetermined price.
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The main economic advantages of floating exchange rates are that they leave the monetary and fiscal
authorities free to pursue internal goals such as full employment, stable growth, and price stability—and
exchange rate adjustment often works as an automatic stabilizer to promote those goals. The main economic
advantage of fixed exchange rates is that they promote international trade and investment, which can be an
important source of growth in the long run, particularly for developing countries. The merits of floating
compared to fixed exchange rates for any given country depends on how interdependent that country is with
its neighbors. If a country’s economy is highly reliant on its neighbors for trade and investment and
experiences economic shocks similar to its neighbors’, there is little benefit to monetary and fiscal
independence, and the country is better off with a fixed exchange rate. If a country experiences unique
economic shocks and is economically independent of its neighbors, a floating exchange rate can be a valuable
way to promote macroeconomic stability. A political advantage of a currency board or currency union in a
country with a profligate past is that it “ties the hands” of the monetary and fiscal authorities, making it harder
to finance budget deficits by printing money.
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Course: Monetary Theory and Policy (811)
Semester: Autumn, 2021
ASSIGNMENT No. 1
Q.1 Discuss in detail the history of evolution of money.
Interestingly enough, money often has no intrinsic value. Instead, money is an object that has a value placed
on it, which allows for the trade of goods and services. Some money, such as metal coins, has actual value in
terms of the materials used. However, paper money is more common in the modern world and typically has
no real value. Throughout the evolution of money, currency has taken several different forms.
Before money was invented, people bartered for goods and services. It wasn’t until about 5,000 years ago
that the Mesopotamian people created the shekel, which is considered the first known form of currency. Gold
and silver coins date back to around 650 to 600 B.C. when stamped coins were used to pay armies. Some
evidence suggests that metal coins may be as old as 1250 B.C.
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When there was no currency, people traded goods and services for what they needed. One farmer might trade
livestock for vegetables, while another may trade labor or lumber for livestock. These transactions were the
early building blocks of our modern economy and would go on to create the future of money the world knows
today.
History of Bartering
The history of bartering dates all the way back to 6000 B.C. when Mesopotamian tribes introduced the
concept to the Phoenicians. Goods were exchanged for each other in the absence of money, including things
like tea, salt, weapons and food. As time went on, bartering continued to evolve, with Colonial Americans
trading pelts, crops and muskets.
First Metal Money – Coins
The first metal money dates back to 1000 B.C. China. These coins were made from stamped pieces of
valuable metal, such as bronze and copper. Early iterations of coins were also used by ancient Greeks, starting
around 650 B.C.
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Over time, these coins would evolve to be made from the silver and gold we associate with money today.
Coins were a huge milestone in the history of money because they were one of the first currencies that allowed
people to pay by count (number of coins) rather than weight.
Early Coins
Throughout history, there have been lots of different coins used in different regions. In about 500 B.C., the
first round coins were created and stamped with gods and emperors for authenticity. In 800 AD, Charlemagne
issued the silver penny, which was the standard coin in Western Europe from 794 to 1200 A.D.
By the mid-13th century, the shilling and pound became widely used to describe larger amounts of pennies.
As the value of currency has changed over the years, the creation of larger forms of currency has been an
important part of the history of money.
First Paper Money
While the first paper money was created in China in 700 to 800 A.D., it would be a long time before paper
currency was commonly used. According to Brittanica.com, the first country to use paper money was China,
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but it was only used until about 1455. The lighter weight of paper money allowed for international trade,
which created both problems—distrust and currency wars—and opportunities—the ability to trade in new
places for new goods.
After China stopped using its paper money during the mid-15th century, coins once again became the most
popular form of money in the country and in the world.
Bills of Exchange
Eventually, bills of exchange became a common part of the world economy. A bill of exchange is essentially
a written order that one person or group will pay a specified amount of money on demand. A bill of exchange
can be used to settle an account in international trade, which was one of the early uses of this order.
Currency Wars
The creation of paper money would eventually lead to currency wars, which occur when leaders of different
nations attempt to devalue their own currency. In turn, this increases demand and helps stimulate their
economy. While this still occurs in today’s foreign exchange market, the signature of a currency war is the
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fact that several nations are involved in the devaluing of other nations’ currencies. However, currency wars
can have negative consequences for the countries involved, including currency volatility.
The Introduction of Banks
The first banks were started by the Roman Empire around 1800 B.C. These banks offered loans and accepted
deposits from individuals, but would later disappear with the collapse of the empire. By the turn of the 19th
century, banks had become respectable organizations within communities and learned the concept of
fractional reserve banking. Since individuals didn’t all withdraw all their money at once, banks learned that
they could loan more money than they actually had, which was a huge step in the history of money.
The Gold Standard
In 1816, gold was made the standard of value in the country of England. What this means is that each
banknote represented a certain amount of gold, so only a limited number of banknotes can be printed. This
gave previously unbacked currency some semblance of value and stability. By 1900, the United States had
followed suit with the Gold Standard Act. While this would lead to the U.S. establishing the central bank that
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plays an important role in the economy today, the Gold Standard ended in the 1930s due to the Depression
and the devaluation of gold.
Modern Day Money
Today, money has taken the form of everything from the U.S. dollar to cryptocurrencies like Bitcoin. Thanks
to the creation of modern-day money, buying, selling, and trading is easier than it’s ever been.
Credit Cards & Debit Cards
When it comes to convenience, credit cards and debit cards are popular choices. A debit card is loaded with
a set amount of money from your bank account, with money being removed from your account after each
purchase you make.
Credit cards are a little different in the sense that they don’t carry a balance that you have to put in. Instead,
lenders can choose a credit limit to set on your card, allowing you to spend up to a certain amount before you
have to start paying it back to continue using your card. Credit cards were first issued to consumers in the
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1920s and have grown in popularity ever since. In 2020, credit cards were the most commonly used payment
method in the U.S.
Online Payments
Money used to be exchanged physically, whether people paid with coins or paper money. However, with the
Internet boom and growth of eCommerce, online payments have increasingly become more convenient.
Today, online payments are one of the most popular ways to pay for goods and services. With online
payments, you can simply enter a credit or debit card number on a website and pay for the goods you want.
Online payments can also be made using a bank account number and routing number, but that process can
take several days. When you make online payments through a debit or credit card, your card is typically
charged right away.
Digital Currency
In the 90s, digital currency tried and failed to get off the ground, but in the 2000s things have changed,
allowing it to grow in popularity and in widespread use. In fact, digital currencies such as cryptocurrency and
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virtual currency play an important role in the economy today. These currencies have a value assigned to them
just like any other type of money, with billions of dollars in digital money being transferred all the time.
Bitcoin was one of the first and biggest forms of digital currency, but virtual currencies and other crypto
options are starting to become more popular as well.
The Impact of Money throughout History
Money is one of the most important parts of human history, leading to some of the biggest and most vital
moments for many nations. The invention of currency allowed people to trade goods and services without
having to barter to find an appropriate price. Paper currency allowed for international trade thanks to its light
weight and relatively small size. Digital currency allows individuals to invest in potentially growing
currencies and spend money in a way that’s more convenient.
Since money was first invented, it’s had an immense impact on how trade is done throughout the world and
how we live today. Not only have wars been fought over money, but some of the most important
advancements we’ve made in human history wouldn’t be possible without it.
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Q.2 Discuss in detail Keynes motives of holding money.
(i) The Transaction Motive:
People like to keep their money in liquid form (cash) to meet their day-to-day expenses during the period
between the receipt and spending of their money. The necessity for liquidity on this account arises to bridge
the gap between the receipt of incomes and its spending.
An individual or a firm receives income at a particular fixed time while its spending is spread over a period
of time and in order to meet these expenses, as and when they arise money in cash is needed. The amount of
money which an individual needs for such expenses depends upon his income. This motive for liquidity has
been called by Keynes as ‘transaction motive*. Liquidity preference on account of this motive is interest-
inelastic.
(ii) The Precautionary Motive:
Besides day-to-day transactions, there are many unforeseen contingencies in the life of individuals for which
they hold money. The desire of the people for holding money under the precautionary motive is devoted to
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fulfill the function of a store of value. It may be compared with a water tank. As there must be some water in
the tank always for one does not know when and for what purpose it may be needed.
Similarly, one must have some cash always, for this may be needed at any moment for rainy days like
unemployment, sickness, disablement etc. Thus, liquidity preference which exists for unforeseen exigencies
of life constitutes precautionary motive. The amount needed in this way depends upon the income of the
individual. Liquidity preference on this account is also interest-inelastic.
(iii) The Speculative Motive:
The third and the last motive for liquidity preference is the desire to earn profits. Many people may think that
the rate of interest in the future will be higher and in order to take advantage of this future increase in the rate
of interest, they may like to keep money in the liquid form to be invested in securities when the rates of
interest actually rise. In the opposite case when the feeling is that interest rates would decline, they will invest
in the present thus reducing the liquidity of money with them. Keynes has called this as ‘Speculative Motive’.
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Price of bonds and rate of interest are inversely related. If the rate of interest is higher, the price bond would
be low and vice-versa. This can be explained with the help of an example. Say a bond of Rs. 100 has been
issued which will carry 5% interest. This implies that whatever may be the price of bond but its holder will
get a return of Rs. 5, essentially.
Now say the rate of interest goes upto Rs. 6, and then Rs. 83.3 as the price of bond will ensure a return of Rs.
5. On the other hand, if the rate of interest declines to Rs. 4, then Rs. 125 as the price of bond will ensure a
return of Rs. 5. Therefore, it is clear when rate of interest goes up, price of bond goes down and vice-versa.
Now the question arises as to how much one should keep money in cash or should invest in bonds and
securities. If one speculates that the rate of interest would be low in future (means a rise in the price of bonds),
he would hold money in cash at present with a view to earn profits by investing in bonds in future.
On the other hand, if he expects that in future rate of interest would be higher (this means a decline in the
price bonds) demand for holding cash at present would decline. Thus, if the speculated rate of interest is low,
the demand for money would be higher and vice-versa.
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Keynes has attached the maximum importance to liquidity preference for speculative purpose. Liquidity
preference for first two motives generally remains fixed. It depends upon the level of income and is interest
inelastic. On the other hand, demand for money or liquidity preference for speculative motive is interest
elastic, i.e., the function of interest.
Q.3 Discuss in detail the Classical theory of rate of interest.
In the classical system, money is neutral in its effects on the economy. It plays no role in the determination
of employment, income and output. Rather, they are determined by labour, capital stock, state of technology,
availability of natural resources, saving habits of the people, and so on. In the classical system, the main
function of money is to act as a medium of exchange.
It is to determine the general level of prices at which goods and services will be exchanged. The quantity
theory of money states that the price level is a function of the supply of money. Algebraically, MV=PT,
where, M, V, P and T are the supply of money, velocity of money, price level, and the volume of transactions
(or total output) respectively.
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The equation tells that the total money supply, MV, equals the total value of output, PT, in the economy.
Assuming V and T to be constant, a change in M causes a proportionate change in P. Thus money is neutral.
It is simply a ‘veil’ whose main function is to determine the general price level at which goods and services
exchange.
The notion of neutrality of money in the classical system is explained in terms of Fig. 1. Where we start with
an initial full employment equilibrium position with No, Qoâ€™ W/Poâ€™ Moâ€™ Po, and Woâ€™ as illustrated in
Panels (A), (B), (C) and (D) of Fig. 1. The initial equilibrium is disturbed when the quantity of money is
increased from M0 to M1. This leads to a rise in effective demand from MV0 to MV1, and shown in Panel
(C).
This raises commodity prices in proportion to the rise in M, since real output O is fixed. In other words, the
rise in the price level is exactly proportional to the rise in the quantity of money, i.e. P0 P1=M0 M1. With
increase in the price level, the money wage rate will rise as rapidly as prices to (Panel D) in order to keep the
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real wage rate W/Po unchanged (Panel B). But with increase in the price level, the real wage rate tends to
decrease from W/Pp to W/P1, as shown in Panel B of the figure.
This increases the demand for labour by more than the supply of labour which is shown by the distance sd in
Panel B. The competitive bidding for labour will ultimately lead to rise in the real wage rate to W/P0 whereby
the labour market equilibrium is restored at point E. Thus the result of an increase in money is to raise money
wages and prices in equal proportion, leaving output, employment and the real wage rate unaffected. It is in
this sense that money is a veil or neutral in the classical system.
The Keynesian View: Monetary Equilibrium:
The Keynesian theory assigns a key role to money. It contends that a change in the money supply can
permanently change such real variables as the interest rate, the levels of employment, output and income.
Keynes believed in the existence of unemployment equilibrium in the economy.
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The existence of unemployment equilibrium implies that an increase in money supply can bring about
permanent increases in the level of output. The ultimate influence of money supply on the price level depends
upon its influence on aggregate demand and the elasticity of the supply of aggregate output.
The Keynesian chain of causation between changes in the quantity of money and in prices is an indirect one
through the rate of interest. So when the quantity of money is increased, its first impact is on the rate of
interest which tends to fall. Given the marginal efficiency of capital, a fall in the rate of interest will increase
the volume of investment.
The increased investment will raise effective demand through the multiplier effect thereby increasing income,
output and employment. Since the supply curve of factors of production is perfectly elastic in a situation of
unemployment, wage and non-wage factors are available at constant rate of remuneration.
There being constant returns to scale, prices do not rise with the increase in output so long as there is any
unemployment. Under the circumstances, output and employment will increase in the same proportion as
effective demand, and the effective demand will increase in the same proportion as the quantity of money.
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But “once full employment is reached, output ceases to respond at all to changes in the supply of money and
so in effective demand.
The elasticity of supply of output in response to changes in the supply, which was infinite as long as there
was unemployment falls to zero. The entire effect of changes in the supply of money is exerted on prices,
which rise in exact proportion with the increase in effective demand”. Thus, so long as there is
unemployment, output will change in the same proportion as the quantity of money, and there will be no
change in prices; and when there is full employment, prices will change in the same proportion as the quantity
of money.
Therefore, Keynes stresses the point that with increase in the quantity of money, prices rise only when the
level of full employment is reached, and not before this.
This is illustrated in Fig. 2, Panels (A) and (B) where OTC is the output curve relating to the quantity of
money and PRC is the price curve relating to the quantity of money. Panel A of the figure shows that as the
quantity of money increases from O to M, the level of output also rises along the OT portion of the OTC
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curve. As the quantity of money reaches OM level, full employment output OQF is being produced. But after
point T the output curve becomes vertical because any further increase in the quantity of money cannot raise
output and the full employment level OQF
Panel B of the figure shows the relationship between quantity of money and prices. So long as there is
unemployment, prices remain constant whatever increase in the quantity of money. Prices start rising only
after the full employment level is reached, In the figure, the price level op remains constant at the OM quantity
of money corresponding to the full employment level of output OQF . But an increase in the quantity of
money above OM raises prices in the same proportion as the quantity of money. This is shown by the RC
portion of the price curve PRC.
Monetary Equilibrium:
So far as the rate of interest is concerned, it is a monetary phenomenon in the Keynesian theory. It is
determined by the demand for and supply of money. The theory is thus characterised as the monetary theory
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of interest. The supply of money is considered to be fixed in the short run by monetary authorities. The
demand for money, also called the liquidity preference, is the desire to hold cash.
There are three motives on the part of the people to hold cash:
(a) Transaction demand for money,
(b) Precautionary demand for money, and
(c) Speculative demand for money.
Money held for transactions and precautionary motives is a function of the level of income. LT = f(Y). It
varies directly with the level of income and inversely with the interest rate.
According to Keynes, it is expectations about changes in bond prices or in the market rate of interest that
determine the speculative demand for money, Ls = f(r). The speculative demand for money is a decreasing
function of the rate of interest.
The higher the rate of interest, the lower the speculative demand for money, and vice-versa. But at a very
low interest rate, the speculative demand for money becomes perfectly elastic. This is the “liquidity trap”
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portion of the demand for money curve. In this range, people prefer to keep money in cash rather than invest
in bonds because purchasing bonds will lead to loss.
Thus the total demand for money is a function of both income and the interest rate:
LT+Ls = f (Y) +f (r)
Or L = f (Y) +f (r)
Or L = f(Y, r)
where L represents the total demand for money.
The necessary conditions for monetary equilibrium in the Keynesian theory are the equality of the money
supply (M) and the demand for money (L) which determines the interest rate,
M= L (=LT+Ls)
This is illustrated in Fig. 3 (A) and (B). The transactions (plus precautionary) demand for money is given by
the curve LT at OY, and OY2 levels in Panel (A) of the figure. At OY1 income level, it is given by OM1 and
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at OY2 level of income by OM1. In Panel (B), the curve L represents the total demand for money consisting
of transactions, precautionary and speculative demand, LT + Ls.
On the horizontal axis, if OM is the total demand for money, and OM2 is transactions (plus precautionary)
demand for money, then M2M is the speculative demand for money:
OM =OM2+M2M
In other words, if OM2 is subtracted from OM, we get the speculative demand for money:
OM-OM2=M2M.
If the money supply is given as MS and it equals the demand for money represented by the curve L at point
E1 it determines the interest rate OR1Thus the necessary conditions for monetary equilibrium at E1 are the
combination of money income OY2 and money interest rate OR1the demand for money, OM2+M2M, is equal
to the supply of money, Ms.
If there is any deviation from the equilibrium position, an adjustment will take place via a change in the
interest rate and level of income. Suppose the rate of interest rises to OR2. This will reduce investment, output,
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employment and income. Assume that the income falls to OY1, as shown in Panel (A) of the figure. In Panel
(B) of the figure with rise in the interest rate to OR2, the total demand for money falls to OM2 which now
consists of OM1 of transactions (plus precautionary) demand and M1M2 of speculative demand.
If the monetary authority reduces the money supply to M2S2 equal to the fall in money demand, the new
monetary equilibrium will be set at point E2 where the L curve intersects it. The opposite will be the case if
the rate of interest falls below OR1 and continues to fall, the economy may be in the “liquidity trap”.
In the Keynesian monetary equilibrium, when the economy is in the ‘liquidity trap,’ there cannot be a further
fall in the rate of interest even if the money supply is increased by the monetary authority. This implies that
there will not be any effect on investment and income. In this situation, money is neutral and monetary policy
has no effect on the economy. Given an interest-inelastic investment function, monetary policy will be
ineffective.
Money is also neutral and plays no role in the Keynesian system in the full employment situation when an
increase in the quantity of money brings about a proportionate increase in the price level, and employment,
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output and income remain unchanged. But money influences the macro variables of the economy in an
important way between these two extreme cases of the liquidity trap and full employment in the Keynesian
system.
To conclude, money plays a significant causal role in the Keynesian theory. “The degree of money’s
importance depends upon its ability to alter money interest rates and upon the degree to which expenditure
categories (consumption, investment, government outlays, and so forth) are sensitive to changes in the
interest rate. To the extent that a given change in the money supply can induce large changes in the interest
rate and that expenditures are highly sensitive to those changes, money matters very much in the Keynesian
system.”
Q.4 Explain Quantity theory of money in detail.
Money neutrality is a concept of monetary economics for which an increase in the supply of money affects
only prices, without impacting the real economy.
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In other words, according to money neutrality, an increase (decrease) in the money supply will determine an
increase (decrease) in the price of goods and services sold, but not in the real amount of goods and services
sold, real GDP, or unemployment.
Supply and Demand for Money
To understand money neutrality, we need to understand the relationship between supply and demand for
money. As in any free market, supply and demand will meet each other at an equilibrium point at a certain
price. For money, the price corresponds to the interest rate paid on the money borrowed. It means that:
• Given the money supply as a constant, the demand for money is a function of the interest rate charged.
• If the interest rate rises, the speculative demand for money falls.
• If the interest rate falls, the speculative demand for money rises.
• For any level of money supply, there is a level of interest rate for which no excess demand or supply
exists.
The equilibrium point is usually referred to as the Equilibrium Interest Rate.
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Actions of Economic Agents
• If the interest rate is above the equilibrium point, there is an excess supply of money. As a result,
economic agents use the liquidity to buy bonds, pushing up their price until the interest rate is back to
the equilibrium rate of interest.
• If the interest rate is below the equilibrium point, there is an excess demand for money. As a result,
economic agents sell bonds, pushing down their prices until the interest rate is back to the equilibrium
rate of interest.
Effects of an Excess Supply of Cash
As in any market, when the supply of a good rises more than demand, such good becomes less valuable, and
its price declines. Similarly, when the supply of money increases, its price (the interest rate) declines.
While the theoretical models help, the effects of interest rates and monetary policy are not so simple.
When there is an increase in money supply, there is an excess supply of cash for businesses and people that
they can use in several ways, such as:
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• They can lend it to other businesses and individuals;
• They can use it for buying financial assets, such as bonds; and/or
• They can use it for buying real assets, goods, and services.
Real Economy and Money Neutrality
While the excess cash can be used to buy goods, services, assets, or for paying workers, the amount of money
in circulation does not affect an economy’s capacity to produce goods and services, which rather depends on
other factors, such as the availability of labor, natural resources, real assets, and factor productivity.
Changing the supply of cash does not change the availability of natural resources, real assets, or labor
productivity. That’s why many economists believe that changing the money supply, at least in the long term,
will only affect the prices of the goods and services sold, as a different amount of money will be spread over
the same amount of goods and services.
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Money Neutrality in the Real World
Some economists support the concept of money neutrality, while others disagree. In general, it can be agreed
that policymakers don’t believe that changes in the money supply do not affect the real economy. If they did,
monetary policy measures, such as cutting or raising interest rates, or quantitative easing/tightening, cannot
be explained.
Policymakers generally believe that, at least in the short term, an increase (decrease) in money will result in
a positive (negative) effect on economic activity.
Money Neutrality and Short-term Changes in Money Supply
While many economists defend money neutrality in the long term, the effects of money supply on the
economy in the short term are difficult to ignore. For example, the excess liquidity created in the short term
can exert an impact on the inflation rate. With inflation rising, holding money becomes less attractive than
holding real assets. As a consequence:
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• People will allocate their resources away from cash and into durable goods or even increase their
consumption of non-durable goods. It will obviously lead to an increase in consumption and GDP and a
decrease in inventory levels.
• Companies will allocate more resources into real assets, potentially increasing their productive capacity
and actual production levels. As a result, industrial production and GDP growth will increase.
Q.5 discuss in detail the role of money in Keynesian System.
The determinants of the equilibrium interest rate in the classical model are the ‘real’ factors of the supply of
saving and the demand for investment. On the other hand, in the Keynesian analysis, determinants of the
interest rate are the ‘monetary’ factors alone.
Keynes’ analysis concentrates on the demand for and supply of money as the determinants of interest rate.
According to Keynes, the rate of interest is purely “a monetary phenomenon.” Interest is the price paid for
borrowed funds. People like to keep cash with them rather than investing cash in assets. Thus, there is a
preference for liquid cash.
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AIOU Code 811 Monetary Theory and Policy Solved Notes Slides In English.pdf

AIOU Code 811 Monetary Theory and Policy Solved Notes Slides In English.pdf

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