Monetary Economics 1 (1).pptx

DEPARTMENT OF ECONOMICS
Complied by
Dr.S.Vishnu Suba
Assist Prof of Economics
MANNAR THIRUMALAI NAICKER COLLEGE (AUTONOMOUS)

UNIT – I
Evolution and Functions Of Money:
Barter System – Definition of Money – Evolution– Classification–Functions and Significance of
money – Defects - Gold Standard – Causes for breakdown of Gold Standard__Gresham’s Law-
Paper Currency Standard – Systems of Note Issue.
Programme : UG
Semester : III
Subject Code: 18UECC31

Introduction :
 Monetary is the relating to money or currency.
 Monetary economics is the economics of the money supply
prices and interest rates and their repercussions on the
economy.
 In a monetary economy, virtually all maket transactions involve
money.

 Monetary economics has both micro economics and macro
economics part .
 Monetary economics is the branch of economics that studies the
different competing theories of money.

FATHER OF MONETARY
ECONOMICS :
NAME : Milton Friedman.
YEAR : 1912-2006.
KNOWN AS : American Economist.
PRICE RECIEVED : In 1976 he recieved Nobel
prize.

BARTER SYSTEM :
 Barter system is an old method of trading.
 Bartering is a system of exchange of some goods with
other goods, where no money ics involved.
 Is the exchange of goods and services between two
parties without any involvement of money.
 First introduced by the tribes of mesopotomia.

ORIGIN :
 Dates back to as old as 6000B.C.
 The initial stages used to trade food,salt,tea,weapons and
spices.

ADVANTEGES OF BARTER SYSTEM :
 It is a simple system devoid of the complex probelms of the
modern monetary system.
 There is no question of over or under production.
 Since goods are produced just to meet the needs of the
society.

 The probelms of international trade,like foreign exchange crisis
and adverse balance of payments, do not exist in the system.
 In this system personal and natural resources are perfectly
utilized.

Disadvantages of barter system :
1. Lack of double coincidence of wants.
2. Difficulty in storing value.
3. Difficulty of divisibility of commodities.
4. Lack of common measures of value.
5. Difficulty in making deferred payments.
6. Lack of specialization.

1.Lack of Double coincidence of wants :
 In barter system goods were exchanged through goods.
 In their process wants of both buyer and seller must
coincidence.
 This is called lack of coincidence of wants in barter
exchange.
 Lack of coincidence of wants make the difficulty of barter
system.
 Money eliminates this problem.

2. Difficulty in Storing value :
 Some goods are perishable.
 They perish in a short - period.
 So, it was not possible to store the goods in barter system
for a long time.

3.Lack of Divisibility of commodities :
 In barter system we cannot divide all the commodities into
small units.
 It is difficult to fix exchange rates for certain goods which
are indivisible.
 It is also one of the problem of barter system.

4.Absence of Common measures of value :
 In barter system there is no common measure of value.
 The two persons who want each other's goods meet by
coincidence, there should bring no common measure of value.

5.Difficulty in Making deferred payments :
 Under barter system future payment for present transaction
was not possible.
 There is probelm of borrowing and lending.

6.Lack of Specialisation :
 A high degree of specilisation is difficult to achieve under the
barter system.
 Specilisation and interdependence is production is only
possible in an expanded market system based on the money.
 No economic progress is possible in a barter system.

MONEY
ORIGIN OF MONEY :
 The word “MONEY” is believed to originate from a temple of
'Juno' located on capitoline at Rome.
 In this ancient world juno was often associated with money.
 The name 'juno' may derive from the etruscan goddess uni and
Moneta either from the latin word 'monera' or the greek word
'moneres'.

 There are three major theories rgarding the origin og
money.
(i) Money was created for trading purposes.
(ii) Money was created for social purposes.
(iii) Money was created for religious purposes.

MEANING :
 Money is anything serving as a medium of exchange.
 It means is widely used and accepted in use of transaction
involving the transfer of goods and services from one person to
another.
 Many people receive for selling their own things and services .

 Money is one of the greatest inventions of mankind.
 Most countries have their own kind of money, like U.S.A dollars and
british pound.
 Money is also called currency or cash.

DEFINITION :
According to prof.Walker “Money is what money
does.”
Crowther defined, “Anything that is generally
acceptable as a means of exchange and which at the same time
acts as a measure and store of value.”

EVOLUTION OF MONEY :
 Money was developed according to needs and requirements.
 Main aim was to remove the shortcomings of the barter system.

 There are five stages of evolution.
1. Commodity money.
2. Metallic money.
3. Paper money.
4. Credit money.
5. Plastic money (OR) Electronic money.

1. Commodity Money :
 Money is the most important inventions of modern times.
 Money has undergone a long process of historical
evolution .
 In the early stage any commodities were used as a
medium of exchange is called as commodity money.
 Example:- Cow,Cloth,Salt,Pearls,Tea,Weapons,etc.

2. Metallic money:
 Commodity money changes into metallic money like gold ,
silver, copper etc.
 Metals were not used as a coin but as a bullion.
 This created the probelm of mesuring the weight and value.

 Next step, standard coins were created.
 They had a standard weight and value.

3. Paper Money:
 People started using metallic money, it was hrdly portable.
 Paper money is regulated and controlled by central bank.
 During transactions paper was used when there were not
enough coins to make payments.

Paper money as a medium of exchange.
At present a very large part of money consists mainly of
currency notes issued by the central bank.

4. Credit Money :
 People keep a part of their cash as deposits with banks which
they can withdraw at their convinence through cheques.
 Cheques ,drafts, credit cards etc these are all credit money.
 It is convenient , safe and easily convertible into cash.
 It is like near money.
 Cheqe is an instrument of a bank which is used for transfer of
money from one bank account to another.

5. Plastic Money :
 The latest type of money is plastic money in the form of
credit cards and debit cards.
 This aim at removing the need for carriying cash to
make transactions.
 It is a symbol of modernity. It is portable,durable and
divisible.

1..Primary Functions
(i) Medium of exchange:
 Medium of exchange is the basic or primary function of money.
 People exchange goods and services through the medium of money.
 It means that money can be used to make payments for all
transactions of goods and services.
 Generally acceptable remove the difficulties of barter system .

(ii) Measures of value :
 Money serves as a measure of value.
 Value of all goods and services is expressed in terms of money.
 It is used to check profits, loss and liabilities.
 It helps to compare value of all commodities.

2. Secondary Functions :
(i)Standard of deferrred payment :
 It means that money acts as a 'standard' for making future payments.
 It has made defferred paymentsmuch easier than before.
 Money plays an important role in lending and borrowing.

 Money is a convenient mode of calculation and payment of
interest amount to be paid in the future.
 It has also led to the creation of financial institutions.

(ii)Store of Value:
 Store of value impiles a store of wealth.
 Money can be easily stored for future use.
 It is the most convenient and economical means of storing
earnings and wealth.
 It serves as a store of value because money has purchasing
power.

(iii) Transfer of value :
 It facilitates buying and selling of goods not only in the domestic
country but also in other parts of the world.
 It becomes necessary to transfer purchasing power from one
place to another.

3.Contigent Functions
(i)Basis of credit :
 Money as a store of value has encouraged savings by people in the
form of demand deposits in banks.
 The demand deposits are used by the commercial banks to create
credit.
 Banks create credit with the help of money.

(ii) Distribution of Social (or) National income:
 Nations income of a country can be measured in money by
aggregating the value of all commodities.
 National income can be distributed to different factors of
production. like land, labour, capital and organizatoions.
 Very difficult to calculate the factor income without money.

(iii) General form of capital :
 Money is the most important liquid asset.
 Money is convenient to store wealth in the form of money.
 Money helps in transforming other forms of capital.

(iv) Maximum Benefit :
 Money helps the consumer and produces in maximizing their
stabilization.
 The consumer equalize the marginal utilities of different goods
purchased with the use of money.
 The firms can also equalize the margined productivities of
different factors of production and maximize their profits.

Signifinance of money :
1.Money has facilitated the process of exchange and promoted trade.
2.Money being a medium of exchange , it helps in the distribution of
national income.
3.Money has made doing savings easier. Increase in savings leads to
increase in investment.

4. Money is an essential condition for the development of an
organized money market.
5.Money and price mechanism, help the state in like allocation of
resources.
6.Money can help in reviving the economy from recession or
depression period.

Classification of Money
Money can be classified as
(i) Full bodied money.
(ii) Representative full bodied money.
(iii) Credit money.

(i) Full Bodied Money :
 Any unit of money, whose face value of the coin was its
commodity value.
i.e money value = commodity value.
 Ex: During the british period, one rupee coin was made of
silver and its value as money was same as is value of a
commodity.

(ii) Representative full- bodied money :
 It refers to money which is usually made of paper. The value
of representative full- bodied money is much higher than its
value as a commodity.
 It is accepted as money as it can be conveniently used for
carrying out transactions.
 Representative full bodied money has two kinds
(a) Convertible paper money.
(b) Inconvertible paper money.

(a) Convertible paper money :
 It refers to the currency notes which are freely convertible
into full-bodied money at anytime at the option of the
holder.
(b) Inconvertible paper money :
This kind of paper money which cannot be convertible into
full-bodied money at the option of the holder.
(Ex) Indian one rupee note is inconvertible paper money.

(iii) Credit Money :
Credit money refers to the money whose intrinsic value is
much lower than its face value.
i,e ; money value > commodity value.
 Bank money consits of the book credit that banks extend to
thier depositions.
ex:- DD,checks, credit and debit cards.

 The various forms of credit money are
(a) Token coin
 Token coins are those whose face value is more than their
intrinsic value.
 In India, coins of the money value of Rs 5,Rs 2 , Rs 1.50p,
20p, 10p and 5p are token coins.

(b) Representative token money :
 It is 100% backed and is fully redeemable in some commodity such
as gold or silver.
 Slip issued aganist commodities and metals which was used as
money.
(c) Promissory notes:
 These are currency notes issued by reserve bank in india.
 These include all currency notes of denominations like Rs 1000 , Rs
500 etc.
 the commodity value of a promissory note is much less than its
money value.

(d) Demand deposits :
 These dposits can be withdrawn from the bank or transferred
from one person to another by issuing a cheque.
 Such deposits do not have backing in terms of any bullion.
 Demand deposits are very convenient for making transactiona
of huge amounts as they remove the risk of carrying large
amounts of cash.

Defects of Money :
Money suffers from the following major defects.
(1) Instability:
 Money is that its value does not remain constant which creates
instability in the economy.
 Too much of money reduces its value and causes inflation.
 Too little of money raises its value and results in deflation.

(2) Inequality of Income :
 Money is responsible for causing the inequalities of income and
wealth in the society.
(3) Growth of Monopolies :
The use of money leads to the concentration of wealth in a few
hands and this gives rise to monopolies.
Growth of monopolies of results in the exploitation of the
workers.

(4) Over-Capitalization :
 Money is responsible for resulting in over-capitalization and
under-capitalization in industry.
(5) Black Money :
Money due to storability characteristic , is the cause of the evil
of black money.

(6) Political Instability :
 Over-issue of money leading to hyper-inflation leads to political
instability and downfall of government.
(7) Moral and social Evils :
Thefts, dacoity, murders, bribery, and other social evils.
Exploitation of the poor, by the rich.

(8) Misuse of Capital :
 Money which is the basis of credit, leads to the creation of more and
more credit creation.
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Gold Standard :
Meaning :
 The gold standard is fixed monetary system under which the
government's currency is fixed.
 The currency is freely convertible at home or abroad into a
fixed amount of gold per unit of currency.
 Exchange rates between countries are fixed.
 If exchange rates rise above or fall below the fixed mint rate
by more than the cost of shipping gold from one country to
another.

Principles of Gold Standard :
 There should be free movenment of gold between countries.
 There should be automatic expansion or contraction of currency
and credit with the inflow and outflow of gold.
 The government in different countries should help facilitate the
gold movenments by keeping their internal price system flexible
in thier respective economics.

Causes for Breakdown of Gold Standard :
1.Violation of Rules of Gold Standard :
 During war period countries did not show commitment to the
free movenment of gold cross border, and other following
gold standard leads to inflationary and deflationary
tendencies.
2.Restrictions on Free Trade:
 During war period most of the gold standard countries
abandoned the free trade policy under the impact of narrow
nationalism and adopted restrictive policies regarding
imports.

3.Maintain both exchange stability as well as price stability :
 This was impossible because stability is generally
accompanied by internal price fluctuations.
4.Unbalanced Distribution of Gold :
 In the Inter war period, U.S.A, and France accumulated too
much gold.
 Eastern Europe and Germany had very low stocks of gold.This
lead to the abandonment of gold standard.

5.External Indebtedness :
 Excessive international indeptedness led to the decline of gold
standard.
6.Excessive use of Gold Exchange Standard :
 The excessive use of gold exchange standard was also responsible
for the breakdown of gold standard.

7.Absence of International Monetary Centre :
 In the absence of such a centre, every country had to keep large
stocks of gold with them and large movenments of gold had to take
place.
 This was not proper and easily manageable.
8. Lack of Cooperation :
 There was complete absence of economic cooperation among
participating countries.

9.Political Instability :
 Political instability among European countries also
responsible fo the failure of gold standard.
10.Great Deprassion (1929-33):
 The world wide great depression gave a final blow to the
gold standard.

Gresham's Law :
 In economics, Gresham's law is a monetary principle
stating that “Bad money drives out good”.
 It is primarily used for consideration and application in
currency markets.
 For example, There are two forms of commodity money
in circulation, which are accepted by law as having
similar face value, the more valueble commodity will
gradually disappear from circulation.

 The law is named after Sir Thomas Gresham (1519-79),a
leading english business pay on and financial adviser to
Queen Elizabeth 1.
Explanation of the law :
 Gresham's law says that lagally overvalued currency will tend
to drive legally undervalued currency out of circulation.
 Gresham's law is the concept of good money (money which
is undervalued or money that is more stable in value)versus
bad money(money which is a overloaded or loses value
rapidly).

 The law holds that bad money drives out good money in
circulation, when both are full legal tender.
 When “bad money”and “good money” are both in circulation
people will use the “bad money”when making purchases and
the “good money” will be hoarded.
 Gesham's law is that an inferior currency, if not limited in
amount, will drive out the superior currency says Marshall.

Good money disappears from circulation through the
following ways :
1.Hoarding:
 People hoard the good money and pass out the bad.
 There is a natural tendency to retain good coins.
2. Melting :
 Both good coins and bad coins are in circulation and have
the same value.
 People prefer to melt good coins to convert them into
ornaments or other items of art.

3. Export to Foreign Countries :
 In payments to the foriegn countries, gold coins are accepted by
weight and not by counting.
 It would be profitable to pay to the foreigners in forms fo new-full-
weight coins rather than old and light-weight coins.
Limitations :
1) Usefulness of good money.
2) Sufficient money supply.
3) Sufficient supply of bad money.
4) Acceptability of bad money.
5) Absence of banking habits.

Paper Currency Standard :
 Paper standard consists of paper money which is unlimited
legal tender and token coins of cheap metals.
 Paper money may be either convertible or in convertible.
 Convertible paper moneyis convertible into gold or silver coins.
 Paper money is inconvertible in gold and still regarded as full
legal tender.
 After the general breakdown of gold standard in 1931, almost
all the countries of the world shifted to the paper standard.

Merits :
1.Economical :
 Under paper standard no gold coins are in circulation and
no gold reserves are required to back paper notes.
 It is the most economical form of monetary standard.
 The poor countries can adopt it without any difficulty.

2.Proper Use of Gold :
 Wastage of gold is avoided and this precious metal beomes
available for industrial , art and ornamental purpose.
3.Elastic of Money Supply :
 The paper currency standard is a highly useful monetary
system because it possesses great elasticity.
 The monetary authority can easily adjust the money supply
with the requirements of the economy.

4.Avoids Deflation :
 A country avoids deflationary fall in prices and incomes which is
the direct consequence of gold export.
5.Useful during Emergency:
 Paper currency is very useful in times of war, when large funds
are needed to finance war.
 It is also best suited to the less developed countries.

6.Internal Price Stability :
 The paper standard ensumes price stability in the country.
 The monetary authority can stabilize the price level by
maintaining equilibrium between demand and supply of
money by an appropriate monetary policy.
7. Portable:
 It is very convenient to carry large sums of paper money from
one place to another.
8. Easy to Count :
 It is easier to count paper money than metallic money.

Demerits :
1.Exchange instability :
 This system is that it leads to instability in exchange rates
whenever there are large fluctuations in external prices as
against internal prices.
 There are wide fluctuations in the foreign exchange rates.

2. Internal Price Instability :
 Domestic price stability, may not be achived in reality.
 The countries now on paper standard experience such
violent fluctuations in internal prices as they experienced
under gold standard before.
3. Inflationary bios :
 As paper notes are inconvertible, there is every likehood of
the government printing notes in excess of the
requirements.
 This leads to excess of money supply and to inflation in the
country.

4.Lacks confidence :
 Paper money lacks confidence as it is not backed by gold
reserves.
5.Lacks durability :
 Paper money has less durability than metallic coins.
 It can be easily destroyed by fire.
6. Unstable :
 Paper money lacks stability because its supply can be
changed easily.

7.Absence of Automatic Working :
 The paper standard does not function automatically.
 To make it work properly, the government has to
interference from time to time.

System of Note Issue
1.Introduction :
 The Reserve bank of india act 1934 provided for the
proportonal reserve system of note issue.
 According to this system the reserve bank had to maintain not
less than 40% reserves in gold coins , bullion and foreign
securities with the provision that gold coins and bullion.
 The remaining 60% of the reserves were to be covered by
rupee securities of government of india.

 The reserve bank of india act was amended in 195 and the
proportional system of note issue was replaced by the
minimum reserve system.
 In 1957, the reserve bank of india act was again amended to
reduce the minimum currency reserve in foreign securities.
 To be maintained by the reserve bank is Rs200 cores, of which
not less than Rs 115cores shold be kept in gold coins and
bullion.

2.Principles of note issuse :
 Central banks follow two principles for note issue.
1. Currency principles.
2. Banking principles.
1.Currency principles :
 According to this principle central bank must issue currency
against gold reserve or any kinds of reserve.
 The condition of the reserve is that the central bank can easily
convert the reserves into cash.

 This principle is safer but create inelaticity.
2. Banking Principles :
 This principle central bank must issue currency on the basis
of demand unlikely to the currency principle.
 This principle tells us that we calculate how much money
flow we need and then we supply the cash on the market.
 This principle is very elastic and very risky.

Five alternative Systems of Currency Note Issue :
1) Fixed Fiduciary System.
2) Maximum Fiduciary System.
3) Proportionl Reserve System.
4) Simple Deposit System.
5) Minimum Reserve System.

1. Fixed Fiduciary System :
 One of the oldest systems of controlling note issues.
 Under this system, a country cane a certain quantity of
notes any reserve.
 The fiduciary limit had to be raised from time to time in
order to meet the growing needs of trade and industry.

Merits :
 The central bank to exercise strict control over note issue
which is important for controlling inflation.
 This method ensures security confidence among people.
Demerits :
 (i) Wastage.
(ii) Inconvenient.
(iii) Inelasticity.

2. Maximum Fiduciary System :
 This system was adopted in france and was in operation upto
1928.
 Under this system there is a maximum limit upto the central bank
is authorized to note issue without any gold reserves.
 The maximum no note is issued without legal sanction.

Merits :
1.Freedom :
 The system is that under it the note issuing authority enjoys
complete freedom as regards reserve.
2. Economy :
 The system is economical in the sense that the reserve of
gold can be kept to the minimum requirements of trade and
industry.

Demerits :
1.Inelasticity :
 If the limit is too low the currency system becomes inelastic.
2.Inflation :
 If the limit is too high there is a danger of over issue of notes.
3. Proportional Reserve System :
 This system a certain percentage of the total notes issued by the
central bank has to be in gold reserves and the remaining in the
form of government securities.

 Example, They issue 70% on gold and remaining 30% on
government securities and commercial bills.
Merits :
1. Simplicity :
 This system is that simple to operate.
2.Elasticity:
 The system is that it is elastic supply can be changed with
changes in the percentage of gold reserves.

Demerits :
1. Uneconomical :
Large quantities of gold reserves have to be
kept which cannot be issued for productive purposes.
2.Inadequacy :
The gold reserves fall, the reduction in currency
in circulation may be more than in proportin to fall in reserves.

4. Simple Deposit System :
 Under this system monetary authority is required to keep 100%
of the gold and silver for every not issued.
 This is also known as full reserve system.
Merits :
1.Society :
 It is safe because there is full banking of the bullion for every
note issued.
2.No over issued :
 There is no possibility of over issue of notes.because the
monetary authority cannot take any arbitrary decision.

Demerits :
1.Inelasticity :
 The money supply cannot be increased without the full backing
of bullion reserves.
2.Unsuitble :
 This system is especially unsuited for poor countries lacking
insufficient quantities of gold and silver.
3.Uneconomical :
 It does not make a profitable use of bullion reserves lying idle
with the monetary authority.

5. Minimum Reserve System :
 The central bank is authorized to issue notes without limit, but it
must keep a statutory minimum reserve of gold and foreign
securities.
 A system has been operating in india since 1956.
Merits :
1.Elasticity and flexibility :
 The system that it imports a high degree of elasticity and
flexibilty to the system of note issue.

2.Highly useful :
 This system is highly useful for developing countries because they
can meet their financial requirement by printing more notes.
3.Economical :
 A small and fixed amount of gold is required to be kept in reserve.
Demerits :
1.Inflamatory Potential :
 The system is highly dangerous because of its inherent inflationary
potential.

2. Public Option :
 Completely ignores the rate of currency reserves in maintaining
people's confidence in the monetary stem of the country.
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UNIT – II Thoeries of Money
Fisher’s Quantity Theory of Money– Cambridge Equation – A Comparison between
Fisher’s and Cambridge Equation–Milton Friedman Quantity Theory of Money-
Keynes Reformulation Quantity Theory of Money.

UNIT - II
1.Fisher's Quantity Theory of Money :
Introduction :
 Irving Fisher lived from 1867 to 1947.
 American economist, most famous for “Fisher equation of
exchange”put forth in his book ,The Purchasing Power of
Money.(1911)
 He was one of the Neo-Classical economists.

Fisher quantity theory of money:
 Fisher's theory explains the relationship between the money
supply and price level.
 The quantity theory of money states that the quantity of money is
the main determinant of the price level.
 According to Fishers,”Other things remaining unchanged,as the
quantity of money in circulation increases, the price level also
increases in direct proportion and the value of money decreases
and vice versa.
 Fisher equation on quantity theory of money
MV=PT (or)P=MV/T
Where M=Money Supply
V=Velocity of money
P=Price level
T=Volume of the Transactions.

 The value of money or the price level is also determined by the
demand and supply of money.
(i) Supply of money :
 The supply of money consists of the quantity of money in
existence(M)Multiplied by the number of times this money
changes hands, i.e the velocity of money(V).
 'V' is the transactions velocity of money which means the
average number of times a unit of money turns over.
 MV refers to the total volume of money in circulation during a
period of times.
 Money is only to be used for all transaction purposes.

(ii) Demand for Money:
 The demand for money is equal to the total market value of all
goods and services transacted.
 It is obtained multiplying total amount of things(T) by average
price level(P).
 The total value of money expenditures in all transactions.
 Supply of money=Demand for money.
i.e MV=PT(or)P=MV/T

Assumptions :
1) P is passive factor in the equation of exchange which is
affected by the other factors.
2) The proportion of M' to M remains constant.
3) V are assumed to be constant.
4) T also remains constant.
5) The demand dor money is proportional to the value of
transactions.
6) The supply of money is assumed as an exogenously
determined constant.

7) The theory is applicable in the long-run.
8) The existance of full employment in the economy.
Criticisms :
1.Constant Velocity Of Money :
 The velocity of money is constant and is not influenced by the
changes in the quantity of money.
 The velocity of money depends upon exogenous factors like
population, trade activities etc. these are stable and change
very slowly over time.

2. Constant Volume of Transactions :
 Total volume is also to be the constant and is not affected by
changes in the quantity of money.
3. Price Level is a Passive Factor :
 This means that the price level is affected by other factors of
equation.
4. Truism :
 Fisher's equation is a simple truism because it states that the
total quantity of money paid for goods and service must equal
their value.
 But it cannot be accepted today.

5.Constants Relate to Different Time :
 Fisher for multiplying M and V because M relates to a point of
time and V to a period of time.
6. Fails to Measure Value of money:
 It cannot explain 'why' there are fluctuations in the price level as
if changes in prices were the most critical and important
phenomenon of the economic system.
7.Neglects Interest Rate :
 It neglects the rate of interest as one of the causative factors
between money and prices.

Cambridge Equation
(or)
Cash- Balance Approach
Introduction :
 The cambridge cash balance approach, is a version of
quantity theory of money.
 It became popular only in the twentieth century.
 Cambridge economists Alfred Marshall, A.C Pigou, Robertson
and J.M Keyens Formulated the cash balance approach.

Explanation:
 According to cash balance approach, the value of money
depends upon the demand for money.
 The cambridge equation focuses on money demand instead of
money supply.
 Cambridge approach money acts as a store of value and its
movement depends on the desirability of holding cash.
 The demand for money is the demand to hold csh for
transactions and precautionary motive.
 The cash balance approach considers the demand for money not
as a medium of exchange but as a store of value.

Cambridge Equations :
(i) pigou's Equation :
 Pigou was the first cambridge economist to express the cash
balance approach. His equation
P=KR/M
Where P= Purchasing power of money (or) Value of money.
K=The proportion of total real resources (or) income.
R=Total national income
M=Supply of money
 The demand for money, according to pigou, consists not only of
legal money or cash but also bank notes and bank balances.

 Pigou modifies his equation as P=KR/M{C+R(1-C)}.
Where ,
C= The proportion of total real income actually held by
people in legal tender.
1-C = The proportion kept in bank notes and bank
balances.
(ii) Robertson's Equation:
 Robertson formulated an equation similar to that of pigou.
 The only difference between the two being that instead of
pigou's total real resources R,Robertson gave the volume of
total tansaction T.

 Robertson's equation is
M=PKT(or) P=M/KT
Where ,
P=Price level
T=Total amount of goods and services.
K=The fraction of T for which people wish to keep
cash.
M=Total quantity of money
 It is the best of all the cambrige equations as it is the easiest.
(iii) Marshall's Equation :
 There are two parts of the marshall's equations.
 One is income part and property part.

 Both part of the equation may be theoritically correct but it is
seen in practice that people bring only their income into
consumption.
Marshall's Equation;
M=KPY
Where ,M= Supply of money.
P=Price level
Y=Total real income
K= The part of real income which people want to
keep with them in the form of cash.

(iv) Keyne's Equation :
 Keynes in his a Tract on Monetary Reform (1923) gave his real
balance quantity equation better than the other cambridge
equations.
 According to him, people always want to have some purchasing
power to finance their day by day transactions.
 Keynes Equation
n=Pk
where,
k=The number of consumption units
n= Total currency in circulation.
P= Price for consumption unit.

Criticisms :
1) Price level does not measure the purchasing power.
2) More importance of total deposits.
3) Neglects other factors.
4) Neglect of saving investment effect.
5) Neglects speculative demand for money.
________________________

Comparison between Fisher's Equation and Cambridge
Equation :
Similarities:
1.Similar Equations :
 Robertson's cash-balance equations , P=M/KT and Fisher's
equation P=MV/T.
 Both the equations use the same symbols with same meanings.
 The only difference lies in V and K.

2.Same Conclusions :
 The price level or the value of money depends upon the money
supply.
 Direct proportionate relationship between the money supply and
the price level.
 Inverse proportionate relationship between money supply and
the value of money.
3. Same Phenomenon of Money :
 Fisher's equation MV+M'V'.
 M of Robertson's and Pigou's equation.
 N of Keynes's equation, i.e; the total supply of money.

Disimilarities :
• Fisher's Equation:
• Fisher's approach emphasises the
supply of money.
• Money is a flow concept.
• P refers to average price level of all
goods and services.
• It is associated with period of time.
• It is concerned with the total
number of transactios.
• K is stable.
• Cambridge Equation :
• Cambridge approach emphasises
the demand for money and supply
of money.
• Money is a stock concept.
• P refers to the prices of consumer
goods.
• It is associated with point time.
• It is concerned with the level of
income.
• K is not necessarily stable.
• Money as a store of value.

Milton Freidman's Quantity Theory of Money :
 Melton Freidman in his essay,”The Quantity Theory of Money-A
Restatement “ published in 1956.
 In his restatement he says that “Money does matter”.
Freidmsn's Theory:
 Freidman says that his quantity theory is a theory of demand for
money and not a theory of output,income or prices.
 The demand for money between two types.

(i) Money is demanded for transaction purposes.
 It serves as a medium of exchange.
(ii) Money is demanded because it is considered as an asset.
 Freidman treats the demand for money as a part of the wealth
theory.
 An increase in real income lead to more than a proportionate
increase in the demand for real cash balance.
 The demand for money depends on three major factors.
1. The total wealth to be held.
2.The price and the return on his form of wealth.
3 The taste and preferences of the wealth owing class.

Concept of Permanent Real Income :
 The permanent real income refers to the amount of income which
an individual can enjoy during a given period without in any way
reducing his wealth.
 Permanent Real Income is the concept of wealth.
According to Freidman, tre are five broad ways to hold wealth.
1.Money : To hold purchasing power, to have command over goods
and services.
2.Bonds : To earn interest.
3.Equifies: This is the asset which ensures the perpetual income in
the form of dividend.

4.Physical goods : Movable or immovable assets which can be the
source of income.
5.Human Wealth : Skill, training and productive efficiency of an
individual.
Freidman's Equation :
M/P= f [Y, w,rm.eb,re,1/p,dp/dt/u]
where
M=Money stock
P=Price level
Y=Permanent Income.
W=Ratio of non human wealth to human wealth.

Rm=expressed ratre of return on money.
Rb=ecxpected rate of return on bonds.
Re=expected rate of return on equities
1/P.dP/dt=The expected rate of return on real assets.
V=other factors except income.
Criticisms:
1. Very Broad definition of money :
 The broad definition of money which not only includes currency
and demand deposits, but also time deposits with commercial
banks.

2.Money not a luxury good :
 Freidman regards money as a luxury good because of the inclusion
of time deposits in money.
3.More Importance to Wealth Variables :
 Demand for money function, wealth variables are preferable to
income and the operation of wealth and income varaiables.
4.Money Supply not exogenous :
 Freidman takes the supply of money to be unstable.
 The supply of money is varied by the monetary authorities in an
exogenous manner in freidman's system.

5.Does not Consider Time Factor :
Freidman does not tell about the timing and speed of adjustment.
6.Ignores the money supply :
Freidmen also ignores the effect of prices output or interest rates
on the money supply.

Keynes Quantity Theory of Money
 Keynes reformulated the quantity theory of money
 According to him, money does not directly affect the price level.
 This will lead to the change in prices of goods and services.
 The effect of money on prices is indirect and non- proportional.
 Assumption : 1. All factors of production are in perfectly elastic
supply so long as there is any unemployment.
2.All unemployment factors are homogenous, perfectly divisible
and inter changeable.
3.There are constant returns to scale so that prices do not rise or
fall as output increases.
4.Effective demand and quantity of money change in the same
proportion so long as there are unemployed resources.

 The keynesian chain of causation between changes in the
quantity of money and in prices is an indirect one through the rate
of interest.
 A change in the quantity of money can lead to change in the rate
of interest, the volume of investment can change.
 This change in investement volume can lead to a change in
income, output and employment along with a change in the cost
of production.
 The reformulated quantity theory of money stresses the point that
with increase in the quantity of money prices rise only when the
level of full employment is reached.

M ------T------------------------------M-------R----
output o prices
 In Diagram (A) and (B) where OTC is the output curve relating to the
quantity of money.
 PRC- price curve relating to the quantity of money.
 Diagram A quantity of money reaches OM level full employement output
OQF.
 In diagram B shows the relationship between quantity of money and
prices.
 OP remains constant at the OM quantity of money and OQ1 full

Criticisms :
1.Direct Relation : The actual effects of monetary changes are
direct.
2.Stable demand for money : Keynes absorbed by changes in the
demand for money.
3.Nature of Money: Keynes belived that money could be exchanged
for bonds only.
4.Effect of Money : Keynes to argue that money had little effect on
income.

UNIT – III Inflation and Deflation
Inflation:
Meaning–Types– Causes and Effects –Inflationary
Gap– Measures to Control Inflation – Current trends in the Rate
of Inflation.
Deflation: Meaning– Causes and Effects--Measures – Phillips
Curve.

Unit- III
Inflation and Deflation
Meaning :
 Inflation is defined as a sustained increase in the price level or a
fall in the value of money.
 When the level of currency of a country exceeds the level of
production, inflation occurs.
 Inflation means there is an increase in the general level of prices
of goods and services over a period of time.
 Rise in the prices of most goods and services of daily use such
as food, clothing, Housing etc.

Definition :
 According to crowther, “Inflation is state in which the value of
money is falling and the prices are rising”.
 According to Coulborn defined as, “Too much money chasing too
few goods”.
 According to Samuleson-Nordhaus, “Inflation is a rise in the
general level of prices”.

Types of Inflation :
1.Creeping Inflation.
2.Walking Inflation / Moderate Inflation.
3.Running Inflation.
4.Galloping Inflation.
5.Hyper Inflation.
6.Demand-pull Inflation.
7.Cost-push Inflation.

Types of Inflation :
1.Creeping Inflation :
 When the rate of inflation slowly increasess over time.
 (Ex) The inflation rate rises from 2% to 3% to 4% a year.
 Creeping inflation may not be immediately noticable but i can
become an increasing problem.
2.Walking Inflation :
 When inflation is in single digits-less than 10%.
 Walking inflation may simply be referred to as moderate inflation.

3.Running Inflation :
 When inflation starts to rise at a significant rate.
 It is usually defined as a rate between 10% to 20% per year.
4.Galloping Inflation :
 This is an inflation rate of between 20% upto 1000%.
 At this rapid rate of price increases, inflation is serious problem and
will be challenging to bring under control.
 Some definitions of galloping inflation may be 20% to 100%.

5.Hyper Inflation :
 Th is reserved for extreme forms of inflation-usually over 1000%.
 hyper inflation usually involves prices changing so fast. The value
of money will rapidly decline.
6.Demand-Pull Inflation :
 This is when the aggregate demand in an economy exceeds the
aggregate supply. This increase in the aggregate demand might
occur due to an increase in the money supply or income or the
level of public expenditure.
 This concept is associated with full employment when altering the
supply is not possible. Take a look at the graph below:

Types of inflation - demand pull inflation:
 In the graph above, SS is the aggregate supply curve and DD is
the aggregate demand curve. Further,
 Op is the equilibrium price
 Oq is the equilibrium output
 Exogenous causes shift the demand curve to the right to D1D1.
Therefore, at the current price (Op), the demand increases by
qq2. However, the supply is Oq.

 Hence, the excess demand for qq2 puts pressure on the price,
increasing it to Op1. Therefore, there is a new equilibrium at this
price, where demand equals supply. As you can see, the excess
demand is eliminated as follows:
 The price rises which leads to a fall in demand and a rise in
supply.

Cost-Push Inflation:
Supply can also cause inflationary pressure. If the aggregate
demand remains unchanged but the aggregate supply falls due to
exogenous causes, then the price level increases. Take a look at
the graph below

Types of inflation - cost push inflation:
In the graph above, the equilibrium price is Op and the equilibrium
output is Oq. If the aggregate supply falls, then the supply curve
SS shifts left to reach S1S1.
Now, at the price Op, the demand is Oq but the supply is Oq2
which is lesser than Oq. Therefore, the prices are pushed high till
a new equilibrium is reached at Op1.
At this point, there is no excess demand. Hence, you can see that
inflation is a self-limiting phenomenon.

1.Primary Causes:
 In a economy, when the demand for a commodity exceeds its
supply then the excess demand pushes the price up.
 This leads to an increase in the price level.
2.Increase in public spending:
 Governmnet spending is an important element of the total
spending.
 It is also an important detterminant of aggregate demand.

3.Deficit financing of government spending:
 There are times when the spending of government increases
beyond what taxation can finance.
 In order to incur the extra expenditure,the government resorts to
deficit financing.
4.Increased Velocity of circulation:
 People tend to spend money at a faster rate increasing the
velocity of circulation of money.
5.Population Growth:
 The population grows,it increases the total demand in the
market.Excessive demand creates inflation.

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