Monetary Economics Exercise Solutions | KalviGavani

The two primary functions of money are: (i) Medium of exchange: Money eliminates the need for double coincidence of wants in barter. It is universally accepted in exchange for goods and services, making transactions smooth and efficient. (ii) Measure of value (Unit of account): Money serves as a common standard for measuring and comparing the values of different goods and services. All prices are expressed in monetary terms, enabling easy comparison and accounting.

The secondary functions of money are: (i) Store of value: Money can be saved and used in the future. Unlike perishable goods, money retains its value over time, allowing people to store purchasing power. (ii) Standard of deferred payment: Money enables borrowing and lending because the value of future payments can be specified in monetary terms. Loans, interest, and debts are settled with money.

The contingent functions of money are: (i) Basis of credit creation: Banks create credit on the basis of their cash reserves. Money facilitates the entire credit system. (ii) Distribution of national income: Money facilitates the distribution of national income among the factors of production as wages, rent, interest, and profit. (iii) Maximisation of welfare: Money enables consumers and producers to maximise their satisfaction and profits respectively by making rational economic choices.

The barter system faced several difficulties: 1. Double coincidence of wants: Both parties must want what the other offers, which is rare. 2. Lack of common measure of value: Without money, there is no standard unit to compare the value of different goods. 3. Lack of store of value: Perishable goods cannot be stored for future use. 4. Difficulty in deferred payments: It is hard to specify and settle future payments in goods. 5. Difficulty in division: Some goods (like a live animal) cannot be divided into smaller units without losing value. 6. Transportation problems: Moving goods for exchange is costly and inconvenient.

Irving Fisher's Quantity Theory of Money is expressed as: MV = PT Where: M = Total money supply in the economy V = Velocity of circulation of money (average number of times a unit of money is used) P = General price level T = Total volume of transactions in the economy Fisher assumed that V and T are constant in the short run. Therefore, P is directly proportional to M — an increase in money supply leads to a proportional increase in the price level. Expanded version: MV + M'V' = PT, where M' = bank deposits and V' = velocity of bank deposits.

Inflation is a sustained increase in the general price level, leading to a decline in the purchasing power of money. Types by cause: 1. Demand-pull inflation: Caused by excess aggregate demand relative to aggregate supply (too much money chasing too few goods). 2. Cost-push inflation: Caused by rising costs of production (wages, raw materials, taxes). 3. Built-in inflation: Caused by the wage-price spiral, where workers demand higher wages to cope with rising prices, which in turn pushes prices higher. Types by severity: 1. Creeping inflation: Less than 3% per year 2. Walking inflation: 3% to 10% per year 3. Running inflation: 10% to 20% per year 4. Galloping/Hyperinflation: More than 20% per year

| Basis | Inflation | Deflation | |---|---|---| | Definition | Sustained rise in general price level | Sustained fall in general price level | | Purchasing power | Value of money falls | Value of money rises | | Debtors | Benefit (repay in cheaper money) | Suffer (repay in dearer money) | | Creditors | Suffer (receive cheaper money) | Benefit (receive dearer money) | | Employment | May increase (demand-pull) | Decreases (reduced demand) | | Production | May increase initially | Decreases | | Business activity | Increases | Declines |

Primary Functions: (i) Medium of Exchange: Money serves as the universally accepted medium for buying and selling goods and services. It eliminates the double coincidence of wants required in barter. The person selling goods accepts money, knowing it can be used to buy other goods. This is the most important function of money — it separates the act of sale from the act of purchase. (ii) Measure of Value (Unit of Account): Money provides a common standard for measuring and comparing the values of all goods and services. Instead of expressing the value of wheat in terms of rice, cloth, or shoes, we express it in rupees. This makes economic calculation and comparison easy. A shop can display the price of every item in monetary terms. Secondary Functions: (iii) Store of Value: Money can be saved and used in the future. Unlike perishable commodities, money does not deteriorate physically. People can store their purchasing power by holding money. However, during inflation, the real value of stored money declines. (iv) Standard of Deferred Payment: Money makes borrowing and lending possible by providing a standard for future payments. Loans, interest, and debts are expressed and settled in monetary terms. In the barter system, specifying future payments in goods was impractical. Contingent Functions: (v) Basis of Credit Creation: The entire banking and credit system is built on money. Banks create credit (deposits) on the basis of their cash reserves. Without money as a medium, the credit system could not function. (vi) Distribution of National Income: Money facilitates the distribution of national income among the factors of production — wages to labour, rent to land, interest to capital, and profit to entrepreneurship. Without money, such distribution would be impossible. (vii) Maximisation of Welfare: Money enables consumers to maximise satisfaction by choosing goods that provide the most utility per rupee. Producers maximise profits by allocating resources to their most productive uses. Rational economic decision-making requires money as a common unit of measurement.

Fisher's Quantity Theory of Money: Irving Fisher's transaction version of the quantity theory is expressed as: MV = PT Where: M = Total money supply (currency + demand deposits) V = Velocity of circulation of money (average number of times a unit of money is used in transactions) P = General price level T = Total volume of transactions Expanded version: MV + M'V' = PT, where M' = bank deposits and V' = velocity of bank deposits. Key Assumptions: 1. V (velocity) is constant — depends on institutional factors like banking habits. 2. T (transactions) is constant in the short run — depends on factors of production. 3. M is the independent variable, determined by the central bank. 4. P (price level) is the dependent variable. Conclusion: Since V and T are constant, P is directly proportional to M. If money supply doubles, the price level doubles. In other words, the value of money is inversely proportional to the quantity of money. Criticisms of Fisher's Theory: 1. Over-simplification: The assumption that V and T are constant is unrealistic. V changes with banking habits, technology, and economic conditions. T changes with output and employment. 2. Supply-side focus: The theory considers only the supply of money and ignores the demand for money (people's desire to hold cash balances). 3. Transaction-based: The theory uses total transactions (PT) rather than income transactions, making it difficult to measure T accurately. 4. Long-run validity only: In the short run, changes in M can affect V and T, not just P. The theory is more valid in the long run. 5. No causal mechanism: The equation MV = PT is an identity, not a causal relationship. It does not explain the mechanism by which M affects P. 6. Ignores savings and investment: The theory does not account for the fact that not all income is spent — savings create a leakage. 7. Assumes full employment: The theory assumes that the economy is always at full employment, which is unrealistic (Keynes showed that underemployment equilibrium is possible). 8. Passive role of money: The theory treats money as a passive veil, merely facilitating transactions, ignoring money's active role in the economy.

Cambridge Cash-Balance Theory: The Cambridge economists (Marshall, Pigou, Robertson) developed an alternative approach focusing on the demand for money rather than the supply side. Equation: M = kY or M = kPY Where: M = Money supply k = Fraction of nominal income that people wish to hold as cash balances P = Price level Y = Real income PY = Nominal income Key Idea: People hold a fraction (k) of their income as cash balances for transactions, precautionary, and speculative purposes. If people wish to hold more money (k increases), the velocity of money falls, and vice versa. Comparison with Fisher's Theory: | Basis | Fisher's Theory | Cambridge Theory | |---|---|---| | Approach | Supply-side (transaction approach) | Demand-side (cash-balance approach) | | Equation | MV = PT | M = kPY | | Focus | Velocity of circulation (V) | Proportion of income held as cash (k) | | Emphasis | How money is spent | Why money is held | | V vs k relationship | V is the turnover rate of money | k = 1/V (the reciprocal) | | Active element | M (money supply) is the active variable | k (demand for money) is the active variable | | Determinant of P | Changes in M cause changes in P | Changes in k (demand for money) can also affect P | | Flexibility | Rigid; V and T constant | More flexible; k can vary | Advantages of Cambridge Theory over Fisher's: 1. It explains why people hold money (liquidity preference), not just how it is spent. 2. It introduces the demand for money, which Fisher's theory ignores. 3. It allows for the possibility that changes in the demand for money (k) can affect the price level, not just changes in money supply. 4. It is closer to Keynes's liquidity preference theory, which builds on the idea of the demand for money.

Inflation is a sustained increase in the general price level, reducing the purchasing power of money. Types by Cause: 1. Demand-Pull Inflation: - Caused by aggregate demand exceeding aggregate supply at full employment. - "Too much money chasing too few goods." - Sources of excess demand: increase in government spending, expansion of credit, rise in exports, increase in money supply. - When the economy is at full employment, additional demand cannot increase output, so prices rise. - Described as a shift of the AD curve to the right beyond the full employment level. 2. Cost-Push Inflation: - Caused by rising costs of production, even without excess demand. - Sources: increase in wages (beyond productivity), rise in raw material prices, increase in taxes, profit margin push by monopolists. - The aggregate supply curve shifts leftward, reducing output and raising prices simultaneously. - Also called supply-side inflation. 3. Built-In (Structural) Inflation: - Caused by the wage-price spiral: workers demand higher wages to cope with rising prices, which increases production costs, which pushes prices higher, which leads to further wage demands. - This creates a self-perpetuating cycle of inflation. Types by Severity: | Type | Rate | Impact | |---|---|---| | Creeping inflation | < 3% per year | Mild; may stimulate growth | | Walking inflation | 3%–10% per year | Concerning; erodes purchasing power | | Running inflation | 10%–20% per year | Serious; requires strong policy action | | Galloping/Hyperinflation | > 20% per year | Devastating; currency loses value rapidly | Effects of Inflation: 1. Debtors benefit; creditors lose. 2. Fixed-income earners suffer (salaried workers, pensioners). 3. Savers lose (real value of savings declines). 4. Uncertainty in business decisions. 5. Redistribution of income from the poor to the rich. 6. Balance of payments problems (imports become costlier, exports may decline). Measures to Control Inflation: 1. Monetary policy: Increase interest rates, reduce money supply (contractionary). 2. Fiscal policy: Reduce government spending, increase taxes. 3. Supply-side measures: Increase production, remove supply bottlenecks. 4. Price controls: Administered prices and rationing. 5. Wage and price freeze: Temporary controls on wages and prices.

A central bank is the apex monetary authority of a country, responsible for regulating the banking system and controlling the money supply. The Reserve Bank of India (RBI) performs the following functions: 1. Monopoly of Note Issue: The RBI has the exclusive right to issue currency notes (except one-rupee notes and coins, which are issued by the Government of India). This ensures uniformity and control over the money supply. 2. Banker to the Government: The RBI manages the government's banking needs — receiving payments, making disbursements, managing public debt, and advising on financial policy. It also sells government securities (treasury bills, bonds). 3. Banker's Bank and Lender of Last Resort: The RBI acts as a banker to commercial banks — it holds their reserves, clears inter-bank transactions, and provides financial assistance when they face liquidity problems (lender of last resort). 4. Controller of Credit: The RBI controls the volume and direction of credit in the economy using: - Quantitative tools: Bank rate, open market operations, cash reserve ratio (CRR), statutory liquidity ratio (SLR), repo rate, reverse repo rate. - Qualitative tools: Margin requirements, credit rationing, moral suasion, direct action. 5. Custodian of Foreign Exchange Reserves: The RBI maintains India's foreign exchange reserves and manages the exchange rate. It buys and sells foreign currency to stabilise the rupee. 6. Promotional Functions: The RBI promotes financial inclusion, agricultural credit, industrial development, and export finance through specialised institutions and regulations. 7. Publication of Data: The RBI publishes reports, bulletins, and statistical data on banking, money supply, and the economy, providing valuable information for policymakers and researchers.