1642570754-1385890268-78005.pptx

BUSINESS
ECONOMICS-II
Prof. Gunjan D Sidhu

SYLLABUS
• Introduction to Macroeconomic Data and
Theory
• Money, Inflation and Monetary Policy
• Constituents of Fiscal Policy
• Open Economy : Theory and Issues of
International Trade

The Reserve Bank of India is
India's central bank and
regulatory body under the
jurisdiction of Ministry of
Finance, Government of India.
It is responsible for the issue
and supply of the Indian rupee
and the regulation of the Indian
banking system.

Money, Inflation and Monetary Policy
• The modern economy is know as money economy. All
economic activities of all economy revolves around
money.
• The term “Supply of money” refers to the total amount of
money in circulation at a particular point of time. It is
total stock of money held by the public. The term public
refers to individuals, business firms, government.
• Growth of money supply in limits is important for any
economy to accelerate economic growth and is important
factor to be considered for ensuring price stability.
• Modern approach considers money and all near money
assets as constituents of money supply.

Determinants of money supply
• Money supply consists of coins, currency notes and demand deposits. While coins and currency
notes are issued by Central Bank, demand deposits are created by commercial banks through
process of credit creation. Apart from control of Central bank and government, there are other
factors which influence money supply.
• Major determinants of money supply are:
1. Monetary Base
2. Extent of monetization
3. Community’s choice
4. Cash Reserve Ratio
5. Budgetary Policy of the Government

1. Monetary Base- it refers to variety of assets owned by Central Bank which forms the basis of issue of currency
notes. Amount of currency notes issued by central bank depends upon size of monetary base. Larger the monetary base,
higher would be supply of money and vice-versa. Monetary base consists of following components:
A- monetary gold stock- stock of gold accumulated over the period of time, domestic production of gold, net of import and
export of gold. If monetary gold stock is more, central bank can issue more currency notes.
B- reserve assets- assets owned by central bank are in the form of government bonds, securities, foreign exchange reserves,
etc. increase or decrease in any one of these would affect money supply. Example; if there is favourable balance of payment,
flow of foreign exchange will increase leading to an increase in money supply and vice versa.
C- credit outstanding of central bank- central bank invests in government securities and bonds. Sale and purchase of these
securities will affect money supply. Whenever central bank purchases securities, it makes payment for the same leading to an
increase in money supply. Central bank can control money supply by varying loans provided and investments made by it.

2. Extent of monetization- monetization refers to use of money as a
medium of exchange. Advanced countries are fully monetized. Money supply
depends upon extent of monetization. Money supply would be more in a monetized
economy compared to non-monetized economy.

3. Community’s choice- choice of community regarding mode of
payment influences money supply. If community decides to make payment in terms
of cash, money supply would be less as transaction would be over then and there. If
payments are made by cheque, bank will be able to create credit and there will be
more money supply in economy. Commercial banks keep certain amount of
deposits as reserve ratio and uses balance money for credit creation. Lower the cash
reserve ratio, higher would be credit creation and more money supply and vice
versa. In advanced countries more payments are made through cheques hence more
money supply. Choice of community depends upon banking habits of people,
development of banking system, income level, etc.

4. Cash Reserve Ratio- it is statutorily fixed by Central Bank. It is ratio
of a bank’s cash holdings to its total deposit liabilities. Credit creation
capacity of commercial banks depend upon cash ratio, amount of deposits
and number of other factors. CRR is very important determinant of credit
creation. There is inverse relationship between CRR and credit creation.
Higher CRR lower credit creation by commercial banks and vice versa. CRR
is used by Central bank to control credit creation by commercial banks and
to control total money supply in an economy.

5. Budgetary policy of the Government- it deals with public revenue,
public expenditure and public debt. All these have impact on money supply. The
effects are:
A- when more taxes are levied, money flows from public to government. Money
supply will be less. When taxes are reduced, money supply will be more.
B- in recent time expenditure incurred by modern government has increased due to
various reasons. This has resulted in more money supply.
C- when government is in debt it will borrow from public and there will be
reduction in money supply. When government repays debt there will be expansion
in money supply.

Velocity of circulation of money
In process of transactions, one unit of currency circulates from one person to another. The average number of times a
unit of currency passes from one hand to another during a given period of time is known as velocity of circulation of
money. It is symbolically represented as “V”.
Suppose total number of notes in circulation is Rs.5000 crores. If on an average note is spent 10 times then total value
of transactions is equal to 5000 X 10= Rs. 50000 crores. Therefore supply of money over a period of time can be easily
estimated. If quantity of money in circulation is represented as “M” and velocity of circulation of money as “V”, then
total supply of money is M X V= MV.
The velocity of circulation of money is interpreted in two ways:
1. Income velocity of money- it is ratio which shows average number of times a unit of money is received as income.
Symbolically it is expressed as V=Y/M (Y national income, M total money supply).
2. Transactions velocity of money- it indicates ratio between value of transactions of goods and services during a
given period and the total amount in circulation. It is expressed as V= PT/M (PT refers to total value of
transactions, M refers to quantity of money supply).

Factors influencing velocity of circulation of
money
1. Regulatory of income- velocity of circulation of money will be high when income is regular and stable. When income is stable
and regular, people will spend more hence velocity will be high.
2. Time interval of income receipts- income is received by people on a monthly, weekly, daily basis. Shorter the duration between
two pay days , higher will be velocity of circulation of money.
3. Methods of payments- payments made in lumpsum, velocity will be low. Payments made in instalments, velocity will be high.
4. Liquidity preference of people- if liquidity preference is high, people hold more cash balances, spend less and hence velocity will
be low, vice versa.
5. Distribution of income- velocity depends on distribution of national income. In any society rich saves more than poor, velocity
will be low. Poor spends more as soon as they receive it, velocity will be high.
6. Business conditions- during boom, transactions will be more, velocity high. During depression, transactions will be less, velocity
low.
7. Speed in transaction of money- if banking system is technologically advanced, it can provide multiple facilitites at a time,
velocity will be high and vice versa.

Demand for money
• The classical school considered money as a medium of exchange and
believed that money is demanded for transaction purposes.
• J.M. Keynes on the other hand emphasised on “store value” function of
money and according to him people demand money to hold it in the form
of cash balances as it is the most liquid asset and can be converted into
any asset without loss of time and value.

The Classical Approach to Demand for Money
• The classical school considered money as a medium of exchange and believed that money is
demanded for transaction purposes. This approach is given by economists like David Hume,
J.S Mill and Irving Fisher.
• The transaction approach to demand for money is explained by Irving Fisher through his
famous equation of exchange. It is expressed as MV= PT (M money supply, V velocity of
circulation of money, P price level, T total volume of transactions).
• MV represents supply side, PT represents demand side and it is equal to value of all
transactions in an economy. Fisher clearly emphasizes the fact that value of goods and
services transacted in an economy is equal to value of money paid for them.

The equation of exchange is based assumptions:
1. Full employment of resources exist in economy.
2. Variables ‘V’ and ‘ T’ in equation are assumed to be constant. Change in ‘M’ do not affect V and T.
3. Velocity of circulation of money is an independent factor. It remains constant in short run.
4. M is fixed by central bank. It is assumed to be a given quantity during a particular period of time.
In the equation MV=PT or M= PT/ V . Here M refers to supply of money and it is equal to demand for money at the
point of equilibrium. Therefore M here refers to demand for money and is denoted as Md.
Md= PT/V. from equation it is clear that demand for money varies directly with P and T and indirectly with V. Thus
demand for money is determined by volume of transactions, velocity of circulation of money and price level.

Criticism of cash transaction approach:
• It is unrealistic to assume ‘T’ transactions, will remain constant.
• It is not possible to have a general price level, which can cover both transactions in goods
and services and capital assets.
Highlights of the classical approach:
1. Demand for money arises due to medium of exchange function of money.
2. Money is demanded mainly for transaction purposes.
3. Demand for money depends upon volume of transactions, velocity of circulation of
money and price level.

The Keynesian Approach to Demand for
Money
• J.M Keynes approach emphasizes both the medium of exchange and store
of value functions of money. Desire of people to hold liquid cash is called
‘liquidity preference’. Liquidity preference of people depends on three
motives:
1. Transactions motive
2. Precautionary motive
3. Speculative motive

1. Transaction motive- individuals and business firms demand money to
meet their day to day transactions. Transaction motive demand for
money is the sum of the demand for money for income and business
motives. This demand is influenced by level of income. It is not affected
by change in rate of interest. It is represented as Lt=f(y) where Lt refers
to demand for money for transactions motive and y refers to level of
income.

2. Precautionary motive- desire of people to hold cash balance to meet
unforeseen emergencies. This motive emphasizes store of value function
of money. This motive is also influenced by level of income. It is
represented as Lp= f(y).
Both transaction and precautionary motives are income determined and
interest inelastic. Keynes represents these two as L1=Lt+Lp since both
depend on level of income it is expressed as L1=f(y) where L1 = Lt +
Lp and y refers to income.
The demand for money for transactionary and precautionary motives is
termed as demand for active cash balances. Demand for active cash
balances is a function of income. The diagram shows positive
relationship between income and demand for active cash balances.
When income is OX1demad for money increases to OY1. when income
increase to OX2 demand for money increase to OY2.

3. Speculative motive- it is termed as demand for money for idle cash balance.
This demand for money is based on store of value function of money. People
wish to hold cash for speculation. This demand for money is influenced by
rate of interest. It in interest elastic. There is inverse relationship. Higher rate of
interest, demand will be less and vice versa.
When rate of interests are high it is better to invest rather than keeping cash for
speculation. There is inverse relationship between prices of bonds and interest
rates. People buy bonds when their prices are low and interest rates are high
and sell when bond prices go up and interest rates are low.
In diagram LL1 is liquidity preference curve explaining inverse relationship
between demand for money for speculative motive and rate of interest. When
rate of interest is OR demand for money is OQ. When it fall to OR1, demand
for money rises to OQ1. when rate falls to OR2, demand rises to OQ2. L1L2
portion of curve represents relationship between very low rate of interest and
demand for money for speculative motive. This is known as ‘liquidity trap’.

Liquidity preference theory of interest
Liquidity preference arises due to three motives, transaction, precautionary,
speculative motive. Total demand for money is to satisfy these three motives.
Other things being equal, if liquidity preference rises, demand for money rises
and rate of interest increases and vice versa.
Supply of money is determined by central bank. Demand for money is in
hands of public. Demand remaining same, if supply increases, rate of interest
will fall and vice versa.
MN is supply curve. It is vertical straight line as money supply is constant. LP
curve is liquidity preference curve. Both curve intersect each other at point E.
OR is equilibrium rate of interest. Supply remaining same if demand for
money rises, LP curve will shift to right. The new LP1 curve intersect supply
curve at point E1. now rate of interest in OR1. thus increase in liquidity
preference will increase the rate of interest and vice versa.

Limitation of liquidity preference theory
• Keynes gave importance to demand for money and supply of money. He
ignored productivity, time preference, etc.
• Vague and contradictory theory.
• Interest is reward for productivity of capital rather than for parting with
liquidity.
• Narrow approach.
• What determines rate of interest in not clear.

Quantity theory of money
Quantity theory of money explains the relationship between quantity of money and price level.
The main proposition of the theory is that changes in quantity of money bring about a direct and
propionate change in the price level.
Price level and value of money are inversely related.
Value of money is nothing but purchasing power of money. When price level rises value of money
falls.
There are two approaches to the quantity theory of money:
1. Cash Transaction Approach
2. Cash Balance Approach

Cash Transaction Approach
• An American economists, Irving Fisher developed this approach. He considered money as medium of exchange. He
has explained it in terms of an equation known as Fisher’s equation of exchange. Equation is MV=PT therefore P=
MV/T (M refers to total quantity of money in circulation, V refers to velocity of circulation of money, T refers to
total volume of trade or transactions).
• According to Fisher V and T remains constant and they are influenced by factors outside the equation. P and M are
directly related to each other. When M changes P will also change directly. M is independent variable and P is
dependent variable and passive in nature.
• Change in M do not affect V and T, changes in V or T do not affect M.
• Example: let us assume M is Rs. 10 lakhs, V=10, T is Rs. 5 lakhs
• P=MV/T 10laks X 10/5 lakhs = Rs.20 per unit
If quantity of money ‘M’ is doubled to Rs.20 lakhs then P = 20 lakhs X 10/ 5 lakhs = Rs. 40 per unit.
Thus other things remaining same, price level varies in direct proportion to the quantity of money.

Criticisms of the Cash Transaction Approach
1. Mere Truism- assumption that V and T are constant in the equation makes it a useless truism.
2. M and P relationship- critics do not agree that there is a direct and proportionate relationship between
M and P. The relationship is an indirect one.
3. Variations in price level- equation cannot explain why prices of some goods rise at a faster rate than the
prices of certain other goods and prices of some goods remain the same even when M changes.
4. One sided- this approach gives importance to supply of money ignoring the demand side.
5. Unitary elastic- Fisher’s equation assumes that elasticity of demand for money is unity. In reality it is
not so.
6. Medium of exchange- this approach considers money as medium of exchange. Store value of money is
ignored.
7. Full employment- it is based on assumption of full exchange but it is not reality.

Cash Balance Approach (Cambridge equation)
• This approach explains quantity theory of money by considering money as store value. This
approach was developed by Cambridge economists Alfred Marshall, Pigou, Robertson, Keynes.
According to them value of anything is determined by demand and supply. Value of money is
determined at point where demand for money is equal to supply of money.
• According to this approach demand for money refers to demand for holding cash balance due to
purchasing power. Supply of money consists of currency notes and bank money. The value of
money according to this approach is determined by demand for money and supply of money.
• Demand for money remaining constant, price level will vary directly with the quantity of money. In
other words, value of money will vary indirectly with quantity of money. Supply of money
remaining the same, if there is increase in demand for money, then people will hold more cash
balances. This will lead to decline in expenditure and fall in price or rise in value of money.

• Alfred Marshall’s equation- Marshall’s cash balance equation is M = KY where M refers to
quantity of money, Y refers to total real income and K refers to fraction of total income which
people want to hold as cash balances. Value of money can be obtained as: P = KY/M (P here is
purchasing power of money) P will vary directly with K and indirectly with M.
• A.C. Pigou’s equation- the equation by Pigou is P =KR/M (P refers to purchasing power of money
or value of money, K refers to that proportion of national income which people want to hold as
cash balances).
• Robertson’s equation- equation is M = KPT therefore P = M/KT
Here M refers to supply of money. T refers to annual volume of transactions in goods and services. K
refers to proportion of T which people want to hold as cash balance. P refers to price level. Here P
changes directly with M and inversely with changes in K or T.

Criticisms of Cash Balance Approach
• Capital goods have been ignored.
• There are three motives influencing demand for money. Speculative motive is ignored.
• Demand for various goods and its effects on prices, income and employment are not
analysed here.
• Extent of change in price level due to change in quantity of money is not explained
clearly.
• Role of rate of interest and other factors are not considered.
• In this approach cash balances held by the people is assumed to be influenced by real
income only. Other factors are ignored.

Inflation
• The term inflation refers to a general rise in price level.
• According to Prof. Crowther “inflation is a state in which the value of
money is falling, i.e, prices are rising”.
• According to Prof Hawtrey, “inflation refers to the issue of too much
currency.”
• Generally, it is regarded as a situation where too much money chases too
few goods.

Causes of inflation
1. Expansion of money supply
2. Increase in disposable income (income available after tax)
3. External demand (more export)
4. Rise in expenditure (increased demand result in rise in price level)
5. Future expectations
6. Inadequate resources
7. Hoarding and black marketing
8. Natural calamities

Effects of Inflation on production
1. Adverse effects on capital formation (less savings less investment)
2. Production distortions (goods demanded by rich gets priority, mass
consumption goods neglected)
3. Hoarding and black marketing
4. Speculation (businessman focuses on speculation rather than on production for
making quick profits)
5. Profit orientation and quality deterioration
6. Erosion in the value of money (reduction in purchasing power of money)

Effects of inflation on distribution of income
and wealth
1. Cost of production increases in inflation. So prices would rise more than rise in
cost of production ensuring higher profits for businessman.
2. Inflation affects different sections differently. It is generally said to be
redistributing income in favour of rich people at the expense of poor.
3. During inflation, traders, businessman, speculators gain maximum profit.
4. Worst affected are fixed income wage earners.
5. Through trade union, labourers try to get higher wages to protect them aginst
inflation.

Effect of inflation on consumption and welfare
1. Inflation reduces consumption of goods and services and affects the
general welfare of the people.
2. Higher prices reduces consumption of goods and lowers the standard of
living of the people.

Social and Political effects on inflation
• Inflation helps rich in getting richer and makes poor people poorer.
• Inequality widens leading to social injustice.
• Inflation provides lot of scope for businessman and traders to earn quick profits.
• It gives rise to seller’s market providing ample scope to all sub-standard products
at high prices.
• Adulteration, black marketing, hoarding of goods prevailing on a large scale.
• People start loosing faith on government.
• Social harmony and political stability are at stake.

Demand Pull Inflation
It refers to that type of inflation which arises due to aggregate demand for
goods and services being more than supply of goods and services.
Demand for goods and services may be more dure to increase in money
supply. Demand pull inflation is associated with level of full employment.

Initially demand curve intersects supply curve at point
E. equilibrium price is OP. when demand increases from
DD to D1D1, supply increases from OQ to OQ1. still
price rises from OP to OP1. supply curve slopes upward
up to point E2 afterwards it becomes vertical straight
line. It implies economy has attained full employment
situation. If demand increases further , price level will
continue to rise further. At full employment level ,
equilibrium price is OP2 and quantity demanded and
supplied is equal to OQ2. if demand increases further,
supply cannot be increased. As a result price level will
continue to rise. This rise is known as demand pull
inflation.

Cost push inflation
• It refers to rise in price level due to rise in cost of production.
• It may also occur due to rise in wage rate or due to rise in rate of profit.

Aggregate demand curve DD intersects aggregate supply curve at
point E. equilibrium price is OP. quantity demanded and supplied is
OQ. When cost of production increase, supply curve shifts upwards.
New supply curve S1S intersects demand curve at point A. now price
is OP1 and equilibrium quantity is OQ1. price has increased, quantity
has declined. This will lead to reduction in employment. To maintain
full employment, govt may increase its expenditure which will
increase demand for goods and services. Demand curve will shift to
D1D1 at point E1. new equilibrium price is OP2. rise in price will
induce trade union to demand higher wages. Hence cost of
production will rise shifting supply curve to S2S. If demand remains
same then S2S will intersect D1D1 at point B and new price is OP3.
if Govt increases its expenditure again to maintain full employment
then again demand curve will shift upwards to D2D2 and new price
will be OP4. thus full employment and output can be maintained
only with rise in price level.

Nature of inflation in developing country
Factors on demand side:
1. Size of population (huge population more demand)
2. Rise in income (rise in demand)
3. Public expenditure ( rise in Govt expense, rise in money supply)
4. Flow of foreign capital (more money supply)

Factors on supply side:
1. Low agricultural output ( scarce supply leads inflation)
2. Inadequate infrastructure (shortage of goods and services)
3. Import prices (more import leads to inflation)
4. Rise in cost of production (increase in price)

Monetary Policy
• Two important instruments of macro economic policy are monetary and fiscal policy.
These policies are used by Government to achieve objectives like full employment,
maintaining stable price level, economic growth.
• Monetary policy is concerned with money supply, credit creation by banks and rate of
interests. It is formulated and implemented by Central Bank.
Main objectives of monetary policy are:
1. Acerating economic growth.
2. Attaining full employment and maintaining it.
3. Ensuring stability in the rate of exchange.

Objectives of monetary policy
1. Monetary policy and economic growth- monetary policy promotes capital formation by
mobilising resources and making it available to investors at right time at reasonable rate of
interest.
2. Monetary policy and price stability- it aims as controlling fluctuations in price level. Instability in
price level leads to inflation or deflation.
3. Monetary policy and full employment- when there is full employment in economy, a higher level
of income, output and improvement in standard of living become possible.
4. Monetary policy and exchange rate stability- many Governments prefer flexible exchange rate
policy so that adjustments can be made as per requirements of the economy.
Central bank tries to achieve these objectives by using various tools/ instruments of monetary policy.

Instruments of monetary policy
Various instruments used by Central Government can be divided into two
parts:
• Quantitative instruments
• Qualitative instruments
Quantitative instruments helps Central bank to control quality if credit,
qualitative instruments are used to control the direction of credit.

Quantitative instruments of monetary policy
1. Bank rate- The bank rate is the rate of interest which is charged by a central bank while lending loans to a
commercial bank. In the event of a fund deficiency, a bank can borrow money from the central bank of a
country. In India’s case that would be the Reserve Bank of India. The borrowing is done as per the basis of
the monetary policy of that country. During inflation Central bank increases bank rate and vice versa.
2. Open market operations- Open market operations refer to the selling and purchasing of the treasury bills and
government securities by the central bank of any country in order to regulate money supply in the economy.
Under this system, the central bank sells securities in the market when it wants to reduce the money supply
in the market. It is done to increase interest rates. Similarly, when the central bank wants to increase the
money supply in the market, it will purchase securities from the market. This step is taken to reduce the rate
of interest and also to help in the economic growth of the country. During inflation Central bank sells
securities and commercial banks buy it. This reduces their cash reserve leading to reduction in credit
creation.

3. Cash Reserve Ratio- Cash reserve ratio is a certain percentage of cash
that all banks have to keep with the RBI as a deposit. This percentage is
fixed by the RBI and is changed from time to time by the central bank itself.
During inflation Central bank increases CRR and vice versa.
4. Statutory Liquidity Ratio- Statutory Liquidity Ratio popularly called SLR
is the minimum percentage of deposits that the commercial bank maintains
through gold, cash and other securities. However, these deposits are
maintained by the banks themselves and not with the RBI or Reserve Bank
of India. During inflation Central bank increases SLR and vice versa.

5. Repo rate-term ‘REPO’ stands for ‘Repurchasing Option’ Rate. It is also known as the
‘Repurchasing Agreement’. People take loans from banks in times of financial crunch and
pay interest for the same. Similarly, commercial banks and financial institutions also face a
shortage of funds. They can also borrow money from the country’s apex bank. The Central
Bank of any nation lends money to commercial banks at an interest rate on the principal
amount. If banks take a loan against any kind of security, then this ROI is Repo Rate.
6. Reverse Repo- Reverse Repo Rate is defined as the rate at which the Reserve Bank of
India (RBI) borrows money from banks for the short term. The Reverse Repo Rate helps the
RBI get money from the banks when it needs. In return, the RBI offers attractive interest
rates to them. The banks also voluntarily park excess funds with the central bank as it
provides them with an opportunity to earn higher interest on surplus money.

Qualitative instruments of monetary policy
• During inflation Central bank takes following measures-
1. Increase bank rate
2. Sells securities
3. Increases CRR
4. Rises the margin requirements
5. Control credit for unproductive and speculative purposes

Inflation targeting
Inflation targeting is a central banking policy that revolves around adjusting
monetary policy to achieve a specified annual rate of inflation. The principle
of inflation targeting is based on the belief that long-term economic growth
is best achieved by maintaining price stability, and price stability is achieved
by controlling inflation.

Unit II OVER

1642570754-1385890268-78005.pptx

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