SYLLABUS

B.Com II SEM (Plain)

Subject – MACRO ECONOMICS

UNIT – I Macro economics – concept nature, importance, limitations,

difference between micro and macro economics.

UNIT – II National Income – Meaning, definition, concept of National

Income, Methods for measuring national income, problem of
calculating national income in India.

UNIT – III Theories of wages, Interest and employment.

UNIT – IV Monitory Theories – supply and demand of theory of money,

price theory of money, liquidity of theory money.

UNIT – V Banking and credit management – commercial banking and

credit control, central banking system, inflation and deflation
of money.

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 B.Com II SEM (Plain) Subject – MACRO ECONOMICS
UNIT-I

Overview of unit 1

Meanin Definiti Nature Impor Microeco Limitatio Interdepend

g of ons of of tance nomics ns of ence
Macro Macro Macro of v/s Macroec between
Econom Econom Macro Macroec onomics
ics ics Econo onomics Micro &
mics Macroecono
mics

Macro

The term macro in English has its origin in the Greek term macros which means large. In the
context of ‘Macroeconomics’ means economics of the large like economy as a whole. Macro
economics deals primarily with the analysis of the relationship between broad economic
aggregates like national income, level of total employment, aggregate consumption, total
investment, general price level, balance of payment, the quantity of money etc. Macroeconomics is
also known as the theory of income & employment it is concerned with the problems of on
employment, economic fluctuation, inflation or deflation international trade and economic growth.

Definitions of Macro Economics

1) According to culberton’s-“Macro economic theory of income employment price and
money.”
2) Accordingly to K.E. Boulding –“Macro economics deals not with individuals quantities as
such but with aggregate income but with national income, not with individuals price but
with price levels, not with individuals output but with national output.”
3) According to Edward Shapiro –Macro economics attempts to answer the truly ‘big’
question of economic life – full employment or unemployment, capacity or under capacity
production.

Nature of Macro Economics

1) Macro economics studies the concept of national income and its different elements and the
method of measurement.
2) It studies problems relating to employment and unemployment. It studies different factors
determining the level of employment.

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 3) Determination of general price level is also studied under macro economics. Problems
relating to inflation and deflation are an important component of macro economics.
4) Change in demand and supply of money have an important impact on the level of
employment. Macroeconomics studies function of money & theories relating to it.
5) Problems relating to economic growth is another important component of macro
economics like plans for overall increase in national income, output, employment are
framed so the economic development of economy as a whole.
6) It also studies issues relating to international trade, export, import exchange rate and
balance of payments are the principal issue in this context.

Importance of Macro Economics

1) Macro economics is helpful for getting us an idea of the functioning of an economic system
it is very essential for a proper and adequate knowledge of behavior pattern of the
aggregative variable, as the description of a large and complex economic system.
2) It says about the study of national income and social accounts. It is the study of national
income which enables us to know that three fourth of the world is living in object poverty
without proper national difficult to formulate proper economic policies.
3) Macroeconomic approaches are of almost importance to analyze and understand the effect
of inflation and deflation different sections of society are affected differently as a result of
charges in the value of money.
4) Economic fluctuation is a characteristics features of the capitalist form of economy. The
economic booms and depression in the level of income and employment follow one another
in cyclical fashion.
5) The study of macro economics is essential for the proper understanding of Micro
economics. No micro economics law could be framed without a prior study of the
aggregate.

Microeconomics v/s Macroeconomics

S.No. Points Microeconomics Macroeconomics

1 Study It studies individual unit It studies aggregate or group of
individual units.
2 Assumption At micro level full At macro level, full employment is not
employment is assumed assumed. Instead equilibrium
which is never found in an employment is assumed which is a
economy. Hence this is an real assumption.
unreal assumption
3 Subject We study demand supply, We study national income, theory of
Matter consumer behavior wage, interest & employment. Theory
production, types of market, of money, theory of international
theory of cost & revenue etc. trade etc.
4 Applicability It is useful in analysis of an It is useful in analysis of aggregate
individual unit like cost of an units such as aggregate demand,
individual good, demand of a aggregate prices or inflation-

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 single good, price of a single deflation, aggregate or national
good. income etc.
5 Usefulness It is less useful to Govt. in It is more useful to Govt. in
to Govt. formulating economic formulating economic policies.
policies.

Limitations of Macroeconomics
Following are the main limitations of macro economics:-
1.Excessive Thinking:-Macro economics suffers from the limitations that it always excessively
thinks in the terms of aggregates and presumes circumstances to be normal and homogeneous but
aggregates may result into heterogeneous character.As Prof.Boulding points:
(a) Six apples+Seven apples=Thirteen apples which constitutes a meaningful aggregate.
(b) Six apples+Seven oranges=Thirteen fruits,which constitues a fairly meaningful aggregates.
(c) Six apples+Seven shoes constitutes a meaningless aggregates.
2.Difference in individual items:-Sometimes while aggregating the variables,the basic
characteristics of the data or the variables is left untouched because there are important
diffrences in the items.Sometimes,the features of individual components may not be true to the
aggregate so macro suffers from the danger of excessive generalisation.
3.Unable to influnce society equally:-An aggregative tendency may not influence the entire
sectors of the economy in the same way.For example,a general rise in price as inflation may not
similar effects on different sectors of the economy.
4.Contradictory:-In aggregates,sometime the contradictory individual aspects are neutralised as
in case of the estimation,prices in agriculture fall,of industrial products rise which have different
affects on individual factors but as an aggregate,there may not be any effect at all.Thus,macro
aggregate reslts may be misleading.
5.Role of less aggregative analysis:-Aggregates itself suffer from certain serious problems due to
statical techniques.The recently introduced computational procedures and programming
techniques hane reduced the role of aggregative analysis.

INTERDEPENDENCE BETWEEN MICRO AND MACRO ECONOMICS

Micro and macro economics are the two sides of the same coin.There is close interdependence
between the two.We cannot analyse the individual behaviour without the assuming to aggregate
and likewise aggregate cannot be effective unless individual variables are kept under considration.
Micro economics contributes towards macro economics in a number of ways as:-
1.Study of economic fluctuations:-Business cycles which are universal in every sector,are
influnced by both individuals and aggregate factors.Unless we reveiw both micro and aggergate
variables,we can not provide an appropriate solution to business cycles.Therfore to study trade
cycles micro and macro economics contribute significantly.
2.Basis of economic laws:-Micro economics acts as a basis macro economics because macro is an
aggregate of individual units.The success and accuracy of aggregates depends on the individual
units.Similarly,macro theories are used by micro economists.

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3.Role in international trade:-In international trade both the approches are used.Economists
have developed their theories on the basis of micro economics presuming full emplyoment of
resources and mobility of factors mof production.However,modern economists looked on the
economy as a whole and recognised the role of aggregates. So genral equlibrium is nothing but an
extension of equlibrium of micro economics.
4.Balance of payments and interdependence:-Balance of payments problem is also a burning
problem for economy.An individual sector may have favourable balance of payments whereas
other sectors,unfavourable balance of payments.On the other hand.the overall position of an
economy is to be assessed from aggregate position of all sectors.
5.Theory of tariffs:-Many economists have propounded that modern macro approaches of
imposing tariffs with the intention of correcting balance of payments position is virtually based on
the theory of monopoly. So micro economics has influenced the modern macro economics theory.

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 UNIT-II

DEFINITIONS OF NATIONAL INCOME

Marshall’s Definition

"The labour and capital of a country acting on its natural resources produce annually a certain net
aggregate of commodities, material and immaterial, including services of all kinds. This is the true net
annual income or revenue of the country or national dividend."

The main defects of marshall's definition are as under –

1. A country produces a number of commodities and services whose correct evalution becomes difficult.
Thus, we cannot get an accurate estimate of the national income of a country.
2. There are some commodities which are used more than once. Thus, there is a possibility that the product
of such commodities may be counted twice. This will give a wrong estimate of the national income.
3. There are some commodities which do not appear in the market and they are consumed directly by the
producers. This normally happens in the case of agricultural commodities. Marshall's definition fails to
provide a measure for such items.

Pigou’s Definition
"National income is that part of the objective income of the community, including of course income derived
from abroad, which can be measured in money."

The limitations of this definition are as following:

1. While calculating national income, Pigou includes only those goods and services which are exchanged for
money. Thus, the services which a person renders to himself, and those which he performs for the sake of
his family or friends should not be regarded as part of national dividend. Thus, the definition does not
provide a correct picture of the national income of a country.
2. This definition is applicable only to developed countries of the world where barter system is not found. It
cannot be used to calculate of the national income of the backward and less developed countries where the
barter system still occupies an important place in the economy.

CONCEPTS OF NATIONAL INCOME

There are different concepts of National Income, namely; GNP, GDP, NNP, Personal Income and Disposable
Income.
1) Gross Domestic Product (GDP): GDP at market price is sum total of all the goods and services
produced in a country during a year within the domestic territory
2) Gross National Product (GNP): GNP at market price is sum total of all the goods and services produced
in a country during a year and net income from abroad. GNP is the sum of Gross Domestic Product at
Market Price and Net Factor Income from abroad
3) GDP at Market Price: If we multiply the total output produced in one year within the domestic
territory , by their ‘Market Prices’, we get GDP at market price.
4) GNP at Market Price : If we multiply the total output produced in one year within the domestic
territory as well as outside the country , by their ‘Market Prices’, we get GNP at market price.
5) Gross Domestic Product at Factor Cost : The gross domestic product at factor cost is the difference
between gross domestic product at market price and net indirect taxes.
6) Gross National Product at Factor Cost : The gross national product at factor cost is the difference
between gross national product at market prices and net indirect taxes.

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 Private Income

Central Statistical Organization defines Private Income as “the total of factor income from all sources and
current transfers from the government and rest of the world accruing to private sector” or in other words
the private income refers to the income from socially accepted source including retained income of
corporation.
NI+ Transfer payment + Interest on public debt +Social security + Profit and Surplus of public
enterprises = Private Income

Personal Income
Prof. Peterson defines Personal Income as “the income actually received by persons from all sources in the
form of current transfer payments and factor income. In other words, Private Income is the Total income
received by the citizens of a country from all sources before direct taxes in a year.
PI = Private Income + Undistributed Corporate Profits – Direct Taxes

Disposable Income
Prof. Peterson defined Disposable Income as “the income remaining with individuals after deduction of all
taxes levied against their income and their property by the government.”
Disposable Income refers to the income actually received by the households from all sources. The
individual can dispose this income according to his wish, as it is derived after deducting direct taxes.
DI = Personal Income - Direct taxes – Miscellaneous receipt of the government.

Methods of calculating National Income

Value added or production or output approach
1) The output approach focuses on finding the total output of a nation by directly finding the total value of
all goods and services a nation produces.
2) Problem of Double counting: Because of the complication of the multiple stages in the production of a
good or service, only the final value of a good or service is included in the total output. This avoids an issue
often called 'double counting', wherein the total value of a good is included several times in national output,
by counting it repeatedly in several stages of production. In the example of meat production, the value of
the good from the farm may be Rs10, then Rs 30 from the butchers, and then Rs 60 from the supermarket.
The value that should be included in final national output should be Rs 60, not the sum of all those
numbers, Rs 90. The values added at each stage of production over the previous stage are respectively Rs
10, Rs 20, and Rs 30. Their sum gives an alternative way of calculating the value of final output.

Income method
The income approach equates the total output of a nation to the total factor income received by residents
or citizens of the nation. The main types of factor income are:
Employee compensation/ salaries & wages (cost of fringe benefits, including unemployment,
health, and retirement benefits);
Interest received net of interest paid;
Rental income (mainly for the use of real estate) net of expenses of landlords;
Royalties paid for the use of intellectual property and extractable natural resources.
Corporate Profits

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Expenditure or Consumption method
The expenditure approach is basically an output accounting method. It focuses on finding the total output
of a nation by finding the total amount of money spent. This is acceptable, because like income, the total
value of all goods is equal to the total amount of money spent on goods
GDP= C+I+G+(X-M)
Where:
C = household consumption expenditures / personal consumption expenditures
I = gross private domestic investment
G = government consumption and gross investment expenditures
X = gross exports of goods and services
M = gross imports of goods and services
Note: (X - M) is often written as XN, which stands for "net exports"

Problems of calculating National Income in India

1) Difficulty in defining the nation – AS the world has become a global village, it is very difficult to
identify the national boundaries has become difficult.
2) Non-marketed service – Services like love, kindness, and mercy has economic value but have no
money value.
3) Possibility of double counting – The possibility of double counting which arises from the failure
to distinguish properly between a final and intermediate product.
4) Transfer payment – Individual get pension, unemployment allowance and interest on public loans,
but whether these should be included in national income is a difficult problem. The best way to
solve the difficulty is to consider only the disposable income of individual or personal income
minus all transfer payments.
5) Capital gains or losses – Commodity product this year is sold next year if at higher price is capital
gain & at loss then capital losses e.g. other example could be selling of shares.
6) Income earned through illegal activities –Such as gambling or illicit extortion cannot be included
in national income.
7) Self-consumed production – In many backward countries, substantial part of the output is not
exchanged for money in market it is being either consumed directly by producer or bartered for
other goods & services in the unorganized sector.
8) Paucity of statistics – According to the national income committee of India, the available statistics,
especially for agriculture & small scale industry are extremely unreliable & incomplete.
9) Inflation may give a false impression of growth in national income – In a country when price
rise, inflation rises even though the production falls & vice versa. It leads to mis-measurement of
national income. ,
10) Difficulties in classifying the commodities – Coal is both household use & industrial use as well
,so is the expenditure on coal consumption , expenditure or an investment.
11) Multiple occupations – The production in agri-industrial, in all sectors is highly scattered and
unorganized making the calculation of national income very difficult.
12) Capital depreciation – Depreciation is charged on profit which lowers national income. But the
problem of estimating the current depreciated value of a piece of capital whose expected life is forty
year is very difficult.

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13) Data problems – There are problems of collecting reliable statistical data abort all the productive
activities in the underdeveloped countries.
14) Illiteracy – The majority of people in the country like India are illiterate & they do not keep any
accounts about the production & sole of their products.

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 Unit –III
THEORIES OF WAGES, INTEREST AND EMPLOYMENT

THEORY OF WAGES
Wages
1) A wage is monetary compensation (or remuneration) paid by an employer to an employee in
exchange for work done. Payment may be calculated as a fixed amount for each task completed (a
task wage or piece rate), or at an hourly or daily rate, or based on an easily measured quantity of
work done.

2) Wages is best associated with employee compensation based on the number of hours worked
multiplied by an hourly rate of pay. For example, an employee working in an assembly plant might
work 40 hours during the work week. If the person's hourly rate of pay is Rs.15, the employee will
receive a paycheck showing gross wages of Rs. 600 (40 x Rs. 15)

Salary
1) Salary is a fixed amount of money or compensation paid to an employee by an employer in
return for work performed. Salary is commonly paid in fixed intervals, for example, monthly
payments of one-twelfth of the annual salary.
2) Salary is best associated with employee compensation quoted on an annual basis. For example,
the manager of the assembly plan might earn a salary of Rs.120,000 per year. If the salaried
manager is paid semi-monthly (perhaps on the 15th and last day of each month), her or his
paycheck will show gross salary of Rs. 5,000 for the half-month.
3) Salary is typically determined by comparing market pay rates for people performing similar
work in similar industries in the same region.

Wages V/s salary

1) Wage earners are paid by the hour whereas Salary earners are paid by the year.
2) Salary earners usually receive paid time when they are not working whereas Wage earners
often have to give up pay for time off, Salaries are often calculated as packages
3) Wage earners get paid more for working more than 40 hours per week, Salary workers are
rarely offered overtime pay.
4) Salaries can contain all kinds of benefits and perks whereas wage doesn’t.

THE SUBSISTENCE THEORY OF WAGES

1) This theory was originated with the Physiocratic School of the French economists and was developed
by Adam Smith and the later economists of the classical school. The German economist Lassalle called
it the Iron Law of Wages or the Brazen Law of Wages. Karl Marx made it the basis of his theory of
exploitation.
2) According to this theory, wages tend to settle at the level just sufficient to maintain the worker and his
family at the minimum subsistence level. If wages rise above the subsistence level, the workers are
encouraged to marry and to have large families. The large supply of labour brings wages down to the
subsistence level. If wages fall below this level, marriages and births are discouraged and under-
nourishment increases death rate. Ultimately, labour supply is decreased, until wages rise again to the

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 subsistence level. It is supposed that the labour supply is infinitely elastic, that is, its supply would
increase if the price (i.e. wage) offered rises.

Criticism of subsistence theory

1) This theory is almost completely outdated and has no such practical application, especially in
advanced countries. The theory was based on the Malthusian Theory of Population. It is
inappropriate to say that every increase in wages must inevitably be followed by an increase in birth
rate. An increase in wages may be followed by a higher standard of living.
2) Ricardo was one of the exponents of the subsistence theory. He stressed the influence of custom and
habit in determining what was necessary for the workers. But habits and customs change over time.
Hence, the theory cannot hold good for a longer period of time, especially of a world characterised by
fast changing habits. Ricardo, therefore, admitted that wages might rise above the subsistence level
for an indefinite period in an improving society.
3) The second criticism against this theory is that the subsistence level is more or less uniform for all
working classes with certain exceptions. The thoery, thus, does not explain differences of wages in
different employment.
4) The third criticism is that the theory explains wages only with reference to supply; the demand side
has been entirely ignored. On the demand side, the employer has to consider the amount of work
which the employee gives him and not the subsistence of the worker.
5) The fourth criticism is that the theory explains the adjustment of wages over the lifetime of a
generation and does not explain wage fluctuations from year to year.
6) The fifth and the final criticism is that the term 'subsistence' has a very vague impression. Does it refer
to the minimum requirements of a modern man or of a tribal savage?

MARGINAL PRODUCTIVITY THEORY OF WAGES

1) The marginal productivity theory was first stated by Von-Thunen. The theory has been developed
by Wicksteed Walras J.B. Clark and many others.
2) Statement of the theory: Marginal productivity theory of wage explains that under perfect
competition a worker's wage is equal to marginal as well as average revenue productivity. In other
words marginal revenue productivity and average revenue productivity (ARP) of a worker
determine his wages.
3) According to this theory wage of a laborer is determined by his marginal productivity. In other
words MRP= M.W. Marginal productivity is the addition made total productivity by employing one
more unit of labour. As the laborers are given money wage their marginal productivity is calculated
in terms of money. This is called marginal revenue productivity (MRP). MRP is the addition made to
the total revenue by employing one more unit of a worker. A producer will maximize his profit
when the wage of a laborer is equal to the marginal revenue product.
4) If MW is greater than MRP (MW > MRP) wage is greater than marginal revenue product. The
producer will sustain loss then. If MW for labour is higher than its marginal revenue product then
the employers get less and pay more. Thus he loses.
5) On the other hand if the producer pays wage less than MRP. (ME < MRP) he will gain. But his gain
will not be maximized. Thus he will gain by employing workers so long when MW = MRP. Thus the
wage of a laborer will be determined where MRP - M.W.

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 VMP = MPP x P.
In Perfect competition MRP = VMP
In imperfect competition MRP VMP
Point E in the diagram is the point of equilibrium where MRP = ARP = MC = AC

Assumptions of marginal productivity theory

(1) Perfect competition prevails in both product and factor market.
(2) Law of diminishing marginal returns operates on the marginal productivity of labour.
(3) Labour is homogeneous.
(4) Full employment prevails.
(5) The theory is based on long run.
(6) Modes of production in constant.

Criticism of marginal productivity theory:

1. The theory is based on the assumption of perfect competition. But perfect competition is unreal and
imaginary. Thus theory seems in practicable.
2. The theory puts too much on demand side. It ignores supply side.
3. Production is started with the combination of four factors of production. It is ridiculous to say that
production has increased by the additional employment of one worker. Employment of an additional
laborer amounts nothing in a big scale industry.
4. The theory is static. It applies only when no change occurs in the economy. Under depression wage cut
will not increase employment.
5. This, theory explains that wages will be equal to MRP and ARP.
6. It is difficult to measure MRP because any product is a joint product of both fixed and variable factors.
7. According to Watson the theory is cruel and harsh. This theory never takes into consideration the
marginal product of old, aged, blind etc.

THE WAGES-FUND THEORY OF WAGES

1) Wages Fund Theory: This theory is associated with the name of J.S. Mill. According to Wages Fund
Theory wages depend upon two quantities, viz.:
(i) The wage fund or the circulating capital set aside for the purchase of labour, and
(ii) The number of labourers seeking employment.
2) Since, the theory takes the wage fund as fixed, wages could rise only by a reduction in the number of
workers. According to this thoery, the efforts of trade unions to raise wages are futile. If they
succeeded in raising wages in one trade, it can only be at the expense of another, since the wage fund

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 is fixed and the trade unions have no control over population. According to this theory, therefore,
trade unions cannot raise wages for the labour class as a whole.
3) This theory has been widely criticised and stands rejected now. Even J.S. Mill himself recanted it in the
second edition of his book 'Principles of Political Economy'. Mill thought that wages were paid out of
circulating capital alone. Whether the source of wages is capital or the present products, has been the
subject of a keen controversy in the past. The fact is that in some cases, where the process of
production is short (e.g., final stages of the productive process), wages are paid out of the present
production. On the other hand, when a process of production is long, the labourer obviously does not
obtain wages from the product of his labour either directly or through exchange. In such cases, wages
mainly come out of capital. This theory is inapplicable in highly industrialized countries, but, it is
applicable in an under-developed country suffering from capital deficiency, where the wages cannot
be increased unless national income is increased and capital accumulated through industrialisation.

MODERN OR SUPPLY –DEMAND THEORY OF WAGES

Modern Theory of Wages:
1) According to this theory, the wages are determined by the interaction of demand and supply as in the
case of ordinary commodity. Thus, this theory is also referred to demand and supply theory.
2) Demand for Labour: According to the modern theory of wages, the demand for labour reflects partly
labourer's productivity and partly the market value of the product at different levels of production.
3) Demand of Labour: The demand of labour depends on:
a) Derived Demand: The demand for labour is a derived demand. It is derived from the demand for
the commodities it helps to produce. Greater the consumer demand for the product, greater the
producer demand for labour required to produce that commodity. It may be observed that it is
expected demand and not existing demand for the product that determines demand for labour.
Hence, the expected increase in the demand for a product will increase the demand for labour.
b) Elasticity of Demand for Labour: The elasticity of demand for labour depends on the elasticity of
demand for commodity. According to this theory, the demand for labour will generally be
inelastic if their wages form only a small proportion of the total wages. The demand, on the other
hand, will be elastic if the demand for product is also elastic or if cheaper substitutes are
available.
c) Prices & Quantities of Co-Operating Factors: The demand for labour also depends on the prices
and the quantities of the co-operating factors. If the machines are costly, the demand for labour
will be increased. The greater the demand for the co-operating factors the greater will be the
demand for labour, and vice versa.
d) Technical Progress: Another factor that influences the demand for labour is technical progress. In
some cases labour and machineries are used in definite proportions.
e) After considering all relevant factors as discussed above, the employer is governed by one
fundamental factor, viz., marginal productivity.
4) Supply of Labour: The supply of labour depends on:
(a) The number of workers of a given type of labour which would offer themselves for employment
at various wage rates, and
(b) The number of hours per day or the number of days per week they are prepared to work,

Over a short period of time, reduction in wages may not cause any reduction in the supply of labour. But if
wages are driven too low, competition among employers themselves will push them up. Even over a long
period, the supply of labour is not very elastic.

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Thus, the supply of labour will depend on the elasticity of demand for income which will vary according to
the worker's temperament and social environment. When the workers' standard of living is low, they may
be able to satisfy their wants with a small income and when they have made that much, they may prefer
leisure to work. That is why it happens that sometimes increase in wages leads to a contraction of the
supply of labour.

5) Interaction of Demand and Supply: The final wage rate is determined by the equilibrium of demand &
supply.

THEORY OF INTEREST

MODERN THEORY OF INTEREST / THE HICKS-HANSEN THEORY OR IS-LM MODEL

In expounding the modern theory of interest, Professor Hansen, in his Monetary Theory and Fiscal Policy,
points out that there are four determinants of the rate of interest:
1. The investment demand schedule;
2. The consumption function;
3. The liquidity preference schedule; and
4. The quantity of money.

Using the classical terminology, there are, four determinants of income and the rate of interest:
(1) productivity;
(2) thrift;
(3) the desire for holding cash; and
(4) the quantity of money or money supply.

The equilibrium condition of these four variables together determines the rate of interest. According to
Hansen, "an equilibrium condition is reached when the desired volume of cash balances equals the quantity
of money.

When the marginal efficiency of capital is equal to the rate of interest, and finally, when the volume of
investment is equal to the normal or desired volume of saving. And these factors are interrelated."

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In short, according to the modern theory of interest, when the four variables, viz. saving, investment,
liquidity preference and the quantity of money, are integrated with income, we get a fairly satisfactory
explanation of the rate of interest.

For this purpose, a synthesis between the loanable funds formulation and the liquidity preference theory is
evolved by neo-Keynesian economists (Hicks, Lerner and Hansen).

In fact, the aim of such a synthesis was to combine the real sector and the monetary sector as well as the
flow and stock variables of these distributive theories (loanable funds and liquidity preference) together as
an explanation of interest rate determination.

Thus, the neo-Keynesian synthesis evolved two schedules, the IS schedule and the LM schedule the former
showing the equilibrium between the flow variables in the real sector and the latter representing the
equilibrium of the stock variables.

When the IS and LM schedules are plotted graphically, their respective curves (the IS curve and the LM
curve) give us the equilibrium rate of interest at the point of their intersection. At this equilibrium rate of
interest:
(i) Total saving = total investment;
(ii) Total demand for money = total supply of money; and
(iii) The real as well as the monetary sectors are in equilibrium.
Let us now see, how these two schedules (IS and LM) and the respective curves are constructed.

The IS Schedule:
1. From the loanable funds formulation, we get a family of loanable fund schedules or saving
schedules at various income levels. These together with the investment demand schedule gives us
the IS schedule, and when represented diagrammatically we get the IS curve.
2. The IS curve denotes equilibrium in the real sector, showing various combinations of the levels of
income (Y) and interest rate (r) at which there is equilibrium between aggregate real saving and
real investment.
3. Now, in order to derive the IS schedule, we have to find out those rates of interest and those levels
of income corresponding to which investment is equal to saving from a given investment schedule
and a given saving schedule. For this, let us construct hypothetical schedules.To present the above
schedules diagrammatically in a generalised form, let Y 1 , Y 2 , Y 3 , Y 4 and V 5 represent respectively
the income levels of Rs.1000, 1500, 2000, 2500 and 3000 crores in the economy.
4. We may assume that at these income levels, S 1 , V 1 , S 2 , Y 2 , S 3 , V 3 , S4 , Y 4 , and S 5 , V 5 curves
represent volumes of savings of Rs. 100, 200, 300, 400 and 500 crores respectively.

It is the investment curve when the income level is Y 1 ; the equilibrium between saving and
investment is established at R 1 M 1 rate of interest (7% in the given illustration).
Or at Y 1 income level, R l M 1 is the equilibrium rate of interest which brings about equality between
saving and investment (in our example, at 7% rate of interest S = 100 crores and / = 100 crores. (S -
I).
Likewise, at the income level Y 3 , R 2 M 2 rate of interest establishes equilibrium between saving and
investment. And in the same manner, at income levels Y 2 , Y 4 and Y 5 , the equilibrium between
saving and investment is established by R 3 M 3 , and R 4 M 4 and R 5 M 5 rates of interest respectively.
Now, connecting together the various rates of interest equalising saving and investment at the
corresponding levels of income, Y 1 ,Y 2 Y 5etc., we then get a curve called the IS.

15
 5. It is easy to see from the diagram that each point along the IS curve gives different income levels at
which the savings and investment are in equilibrium.
6. The IS curve slopes downward to the right for the simple reason that at higher levels of income,
saving is greater, but the greater the saving, the lower the rate of interest.Thus, as the level of
income rises, the rate of interest declines, with increasing saving. And, as the rate of interest
declines, investment rises till saving equals investment.

The LM Schedule:
1. In order to observe the monetary sector equilibrium in the theory, neo-Keynesians have derived the
LM schedule or curve from Keynes' liquidity preference theory.
2. It has been pointed out that the liquidity preference function L and the money supply M also
establish a relation between the income and the rate of interest. Hansen states that from the
Keynesian formulation we get a family of liquidity preference schedules at various income
levels.These, together with the supply of money fixed by the monetary authority, give us the LM
schedule. The LM schedule tells us what the various rates of interest will be (given the quantity of
money and the family of liquidity preference schedules) at different levels of income.
3. In fact, the LM schedule shows the relation that (given a certain liquidity or demand schedule for
money) and a certain quantity of money fixed by the monetary authority; the rate of interest will be
low when income is low and high when income is high.
4. Thus, the LM schedule is the schedule showing the relation between income and interest (given the
L function and the supply of M) when the desired cash equals the actual cash, or when L - M.This
means, the LM schedule presupposes equilibrium between L and M, just as the IS schedule
presupposes equilibrium between I and S 4 .

Determination of the Rate of Interest:

According the modem theory of interest, the intersection of the IS and LM curves determines the rate of
interest. Y" is how the real sector and the monetary sector are integrated by the neo-Keynesian synthesis in
explaining interest rate determination.

It appears from this figure that:

1. With a given LM curve, when the IS is shifted to the right, income rises and the rate of interest also rises.
2. When the IS curve is constant and the LM curve is shifted to the right, the rate of interest falls and so on.
Thus, for a determinate theory of interest, we should view the interaction of the following factors: (1) the
investment-demand function, (2) the saving function, (3) the liquidity preference function, and (4) the
supply of money. Hansen, states that the Keynesian analysis, in a broad sense, involves all these.
In this sense, Keynes, unlike the neo-classicists, did formulate a determinate interest theory. But he failed
to bring all the elements together in a comprehensive manner to formulate plainly an integrated theory of
interest.

16
He, however, did not realise that liquidity preference plus the quantity of money can furnish not the rate of
interest but only an LM schedule.
Thus, the credit goes to Professor Hicks for using the Keynesian tools in a proper manner to construct a
comprehensive and determinate theory of interest.
In short, the modern theory of interest holds that productivity, thrift, liquidity preference, and the money
supply are all important determinants of the rate of interest.

THE LIQUIDITY PREFERENCE THEORY OF INTEREST

1) What is liquidity preference : Liquidity means shift ability without loss. It refers to easy convertibility.
Money is the most liquid assets. Money commands universal acceptability. Everybody likes to hold assets in
form of cash money. If at all they surrender this liquidity they must be paid interest. As water is liquid and
it can be used for anything at will, so also money can be converted to anything immediately.

Demand for money:

(a) The transaction motive:-
An individual for his day to day transaction demand money. A man has to buy food and medicines in his day
to day life. For this purpose people want to keep some cash with them.
(b) The precautionary motive:
People demand to hold money with them to meet the unforeseen contingencies. An individual may become
unemployed; he may fall sick or may meet serious accident. For all these misfortune, he demands money to
hold with him. The amount of money under the precautionary motive depends on the individual's
condition, economic as well as political which he lives.
(c) Speculative motive:
Under speculative motive people want to keep each with them to take advantage of the charges in the price
of bonds and securities. People under speculative motive hold money in order to secure profit from the
future speculation of the bond market. Money under the above three motives constitute the demand for
money. An increase in the demand for money leads to a rise in the late of interest, a decrease in the demand
for money leads to a fall in the rate of interest.

Supply of Money:
The supply of money is different from the supply of ordinary commodity. The supply of commodity is a
flow whereas the supply of money is a stock. The aggregate supply of money in a community at any time is
the sum of money stock of all the members of the society. The supply of money is controlled by the govt.
The supply of money in existence consists of legal tender money, bank money and credit money. The
supply of money is determined by the central bank of a country. The total supply of money is fixed at a
particular point of time. The supply of money is not influenced by the rate of interest.

Equilibrium rate of interest:

The rate of interest is determined by the demand for money and supply of money. The equilibrium rate of
interest is fixed at that point where supply of and demands for money are equal. If the rate of interest is
high peoples demand for money (liquidity preference) is low. The liquidity preference function or demand
curve states that when interest rate falls, the demand to hold money increases and when interest rate
raises the demand for money, diminishes.

17
 THEORY OF UNEMPLOYMENT

Types of unemployment
1) Frictional unemployment :Frictional unemployment is a kind of unemployment that
occurs when people are “between jobs” or are looking for their first jobs. It is a kind of
unemployment that occurs when the economy is trying to match people and jobs correctly. So, if
you get fired for poor work, if you quit because you dislike your job, or if you are just looking for
your first job, you are frictionally unemployed.
2) Seasonal unemployment : Seasonal unemployment occurs when people are not working
because their jobs only exist at some times of the year. Agricultural and construction workers are
examples of this type of unemployment.
3) Structural unemployment Structural unemployment occurs when a given set of skills is
no longer needed in a given economy. For example, E.g. closure of mines, left many miners
struggling to find suitable work. For example, there may be jobs available in the service sector, but
unemployed miners don’t have the relevant skills to be able to take the jobs
4) Cyclical unemployment : Cyclical unemployment, which economists say is the worst
kind. In this kind of unemployment, people are out of work because the economy has slowed and
there is no demand for whatever the workers make. This sort of unemployment occurs during
recessions.
5) Voluntary unemployment: is a situation when a person is unemployed because of not
being able to find employment of his/her own choice. It is a situation when a person is
unemployed. Sometimes people reject employment opportunities if they do not receive desired
wages or if they are not offered the kind of work they wish to do.
6) Disguised Unemployment: Disguised unemployment is the most widespread type of
unemployment in under-developed countries. In under-developed countries, the stock of capital
does not grow fast. The capital stock has not been growing at a rate fast enough to keep pace with
the growth of population, the country’s capacity to offer productive employment to the new
entrants to the labour market has been severely limited. This manifests itself generally in two
ways: (i) the prevalence of large-scale unemployment in the urban areas; and (ii) in the form
of growing numbers engaged in agriculture, resulting in ‘disguised unemployment’

CLASSICAL THEORY OF UNEMPLOYMENT

The classical theory of employment is based on the following assumptions.
1. There is existence of full employment without inflation.
2. There is a closed laissez-faire capitalistic economy.
3. There is perfect competition in labor market and product market.
4. Labor is homogenous.
5. Total output of the economy is divided between consumption and investment expenditure.
6. The quantity of money is given.
7. Wages and prices are flexible.
8. Money wages and real wages are directly related and proportional.

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The main Postulates of classical theory are:
1) The basic contention of classical economists was that if wages and prices were flexible, a
competitive market economy would always operate at full employment. That is, economic forces
would always be generated so as to ensure that the demand for labour was always equal to its
supply.
2) In the classical model the equilibrium levels of income and employment were supposed to
be determined largely in the labour market. At lower wage rate more workers will be employed.
That is why the demand curve for labour is downward sloping. The supply curve of labour is
upward sloping because the higher the wage rate, the greater the supply of labour.
In the following figure the equilibrium wage rate (wo) is determined by the demand for and the
supply of labour. The level of employment is OLo.

The lower panel of the diagram shows the relation between total output and the quantity of the
variable factor (labour). It shows the short-run production function which is expressed as Q = f ( K,
L ), where Q is output, K is the fixed quantity of capital and L is the variable factor labour. Total
output Qo is produced with the employment of Lo units of labour. According to classical
economists this equilibrium level of employment is the ‘full employment’ level. So the existence of
unemployed workers was a logical impossibility. Any unemployment which existed at the
equilibrium wage rate (Wo) was due to frictions or restrictive practices in the economy in nature.

19
3) The classical economists believed that aggregate demand would always be sufficient to absorb
the full capacity output Qo. In other words, they denied the possibility of under spending or
overproduction. This belief has its root in Say’s Law.

(a) Say’s Law: According to Say’s Law supply creates its own demand, i.e., the very act of
producing goods and services generates an amount of income equal to the value of the goods
produced. Say’s Law can be easily understood under barter system where people produced
(supply) goods to demand other equivalent goods. So, demand must be the same as supply. Say’s
Law is equally applicable in a modern economy. The circular flow of income model suggests this
sort of relationship. For instance, the income created from producing goods would be just
sufficient to demand the goods produced.

(b) Saving-Investment Equality: There is a serious omission in Say’s Law. If the recipients of
income in this simple model save a portion of their income, consumption expenditure will fall
short of total output and supply would no longer create its own demand. Consequently there
would be unsold goods, falling prices, reduction of production, unemployment and falling incomes.
However, the classical economists ruled out this possibility because they believed that whatever is
saved by households will be invested by firms. That is, investment would occur to fill any
consumption gap caused by savings leakage. Thus, Say’s Law will hold and the level of national
income and employment will remain unaffected.

(c) Saving-Investment Equality in the Money Market: The classical economists also argued that
capitalism contained a very special market – the money market – which would ensure saving
investment equality and thus would guarantee full employment. According to them the rate of
interest was determined by the demand for and supply of capital. The demand for capital is
investment and its supply is saving. The equilibrium rate of interest is determined by the saving-
investment equality. Any imbalance between saving and investment would be corrected by the
rate of interest. If saving exceeds investment, the rate of interest will fall. This will stimulate
investment and the process will continue until the equality is restored. The converse is also true.

(d) Price Flexibility: The classical economists further believed that even if the rate of interest
fails to equate saving and investment, any resulting decline in total spending would be neutralized
by proportionate decline in the price level. That is, Rs 100 will buy two shirts at Rs 50, but Rs 50
will also buy two shirts if the price falls to Rs 25. Therefore, if households saves more than firms
would invest, the resulting fall in spending would not lead to decline in real output, real income
and the level of employment provided product prices also fall in the same proportion.

(e) Wage Flexibility: The classical economists also believed that a decline in product demand
would lead to a fall in the demand for labour resulting in unemployment. However, the wage rate
would also fall and competition among unemployed workers would force them to accept lower
wages rather than remain unemployed. The process will continue until the wage rate falls enough
to clear the labour market. So a new lower equilibrium wage rate will be established. Thus,
involuntary unemployment was logical impossibility in the classical model.

20
Keyne’s Criticism of Classical Theory:
J.M. Keynes criticized the classical theory on the following grounds:
1. According to Keynes saving is a function of national income and is not affected by changes in the
rate of interest. Thus, saving-investment equality through adjustment in interest rate is ruled out.
So Say’s Law will no longer hold.
2. The labour market is far from perfect because of the existence of trade unions and government
intervention in imposing minimum wages laws. Thus, wages are unlikely to be flexible. Wages are
more inflexible downward than upward. So a fall in demand (when S exceeds I) will lead to a fall in
production as well as a fall in employment.
3. Keynes also argued that even if wages and prices were flexible a free enterprise economy would
not always be able to achieve automatic full employment.

SAYS LAW OF MARKET

1) Say’s Law is the foundation of classical economics. Assumption of full employment as a

normal condition of a free market economy is justified by classical economists by a law known
as ‘Say’s Law of Markets’. It was the theory on the basis of which classical economists thought that
general over-production and general unemployment are not possible.
2) Say’s law states that the production of goods creates its own demand

The basic consumptions of says law are :

(a) Perfectly competitive market and free exchange economy.
(b) Free flow of money incomes. All the savings must be immediately invested and all the
income must be immediately spent.
(c) Savings are equal to investment and equality must bring about by flexible interest rate.
(d) No intervention of government in market operations, i.e., a laissez faire economy, and there
is no government expenditure, taxation and subsidies.
(e) Market size is limited by the volume of production and aggregate demand is equal to
aggregate supply.
(f) It is a closed economy.

The Says law has the following implications:

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 1. Production creates market (demand) for goods: when the producer obtained the
various inputs to be used in the production process they generate the necessary income.

2. Barter system is its basis: in its original form the law is applicable to a barter economy where
goods are ultimately sold for goods. Therefore, whatever produced is ultimately consumed in the
economy.

3. General over production is impossible: if the production process is continuing under normal
condition, then there will be no deficiency for the producer in the market. According to say, work
being unpleasant no person will work to make a product unless he wants to exchange it for some
other product which he desires therefore the very act of supplying goods implies a demand for
them. In such a situation there cannot be general overproduction because the supply of goods will
not exceed demand as a whole.
4. Saving investment Equality: Income occurring to the factors owners in the form of rent, wages
and interest is not spent on consumption but some proportion out of it is saved which is
automatically invested for further production.

5. Rate of interest as a determinant factor: If there is any gap between saving and investment,
the rate of interest brings about the equality between two

6. Flexibility between interest and wage rate: The theory assumes the part of income is saved
and available for investment. If at any point of time saving is more then investment, the rate of
interest will fall, which will result in low savings and more investments. At a lower rate of interest,
household will like to save less, where as producers will like or invest more and economy will be
in equilibrium.If there are unemployed persons in an economy, wage rate will fall. This will induce
entrepreneurs to demand more labor. Ultimately all labor will be absorbed. The economy will be
in full employment equilibrium.
This view suggests that the key to economic growth is not increasing demand, but increasing
production. Say’s views were expanded on by classical economists, such as James Mill and David
Ricardo.

Pigou’s Formulation of Says law

1. According to Professor Pigou, the unemployment which exists at any time is because of the
fact that changes in demand conditions are continually taking place and that frictional resistances
prevent the appropriate wage adjustment from being made instantaneously.
2. Thus, according to classical theory, there could be small amounts of ‘frictional
unemployment’ attendant on changing from one job to another but there could not be ‘involuntary
unemployment’ for a long period.
3. According to Professor Pigou, if people were unemployed, wages would fall until all seeking
employment were in fact employed.
4. Involuntary unemployment which was found at times of depression was because of the fact
that wages were kept too high by the actions of labour unions and governments. Therefore,
Professor Pigou advocated that a general cut in money wages at a time of depression would
increase employment.

22
5. According to Pigou, perfectly elastic wage policy would abolish fluctuations of employment
and would ensure full employment.

Criticism of Classical Theory

1. Supply may not create its own demand when a part of the income is saved. Aggregate
demand is not always equal to aggregate supply.
2. Employment in a country cannot be increased by cutting general wages.
3. There is no direct relationship between wages and employment.
4. Interest rate adjustments cannot solve savings-investment problem.
6. Classical economists have made the economy completely self-adjusting and self-reliant. An
economy is not so self-adjusting and government intervention is unobvious.
7. Classical economists have made the wages and prices so much flexible. In practical,
wages and prices are not so flexible. It will create chaos in the economy.
8. Money is not a mere medium of exchange. It has an essential role in the economy.
9. The classical theory has failed to explain the occurrence of trade cycles.

KEYNESIAN THEORY OF EMPLOYMENT

1) Keynes has strongly criticised the classical theory in his book ‘General Theory of
Employment, Interest and Money’. His theory of employment is widely accepted by modern
economists. Keynesian economics is also known as ‘new economics’ and ‘economic revolution’.
Keynes has invented new tools and techniques of economic analysis such as consumption
function, multiplier, marginal efficiency of capital, liquidity preference, effective demand, etc.
2) In the short run, it is assumed by Keynes that capital equipment, population, technical
knowledge, and labour efficiency remain constant. That is why, according to Keynesian theory,
volume of employment depends on the level of national income and output. Increase in national
income would mean increase in employment. The larger the national income the larger the
employment level and vice versa. That is why, the theory of Keynes is known as ‘theory of
employment’ and ‘theory of income’.

Keynes Theory can be explained as:

1) Effective Demand: According to Keynes, the level of employment in the short run depends
on aggregate effective demand for goods in the country. Greater the aggregate effective demand,
the greater will be the volume of employment and vice versa. According to Keynes, the
unemployment is the result of deficiency of effective demand. Effective demand represents the
total money spent on consumption and investment. The equation is:
Effective demand = National Income (Y) = National Output (O)
The deficiency of effective demand is due to the gap between income and consumption. The gap
can be filled up by increasing investment and hence effective demand, in order to maintain
employment at a high level.
2) According to Keynes, the level of employment in effective demand depends on two factors:
(a) Aggregate supply function, and
(b) Aggregate demand function.

23
(a) Aggregate supply function:
1. According to Dillard, the minimum price or proceeds which will induce employment on a
given scale, is called the ‘aggregate supply price’ of that amount of employment.
2. If the output does not fetch sufficient price so as to cover the cost, the entrepreneurs will
employ less number of workers.
3. Therefore, different numbers of workers will be employed at different supply prices.
4. Thus, the aggregate supply price is a schedule of the minimum amount of proceeds required
to induce varying quantities of employment.
5. We can have a corresponding aggregate supply price curve or aggregate supply function,
which slopes upward to right.

(b) Aggregate demand function:

1. The essence of aggregate demand function is that the greater the number of workers
employed, the larger the output. That is, the aggregate demand price increases as the amount of
employment increases, and vice versa.
2. The aggregate demand is different from the demand for a product. The aggregate demand
price represents the expected receipts when a given volume of employment is offered to workers.
3. The aggregate demand curve or aggregate demand function represents a schedule of the
proceeds of the output produced by different methods of employment.

Significance of Keynesian Theory:

1. Keynes has given a new approach, i.e., Macro-approach to the field of economics. His theory
has several names: theory of income and employment, demand-side theory, consumption theory,
and macro-economic theory. In fact, he has brought about a revolution in economic analysis, often
known as ‘Keynesian Revolution’.
2. Keynes’ theory has completely demolished the idea of full-employment and forwards the
idea of under-employment equilibrium. He states that employment level in the economy can only
be increased by increasing investment.
3. The new economic tools and techniques developed by Keynes have enabled the today’s
economists to draw correct conclusions on the economic situation of a country. Such tools are
consumption function, multiplier, investment function, liquidity preference, etc.
4. Keynes has integrated the theory of money with the theory of value and output.
5. Keynes has first time introduced a dynamic economic theory, in order to depict more
realistic situation of the economy.
6. He also states the reasons of excess or deficiency of aggregate demand through inflationary
and deflationary gap analysis.
7. Keynes’ theory is a general theory and therefore, can be applied to all types of economic
systems.
8. Keynes influenced on practical policies and criticised the policy of surplus budget. He
advocated deficit financing, if that sited the economic situation in the country.
9. Keynes has emphasised on suitable fiscal policy as an instrument for checking inflation
and for increasing aggregate demand in a country. He advocated extensive public work
programmes as an integral part of government programmes in all countries for expanding
employment.

24
10. He advised several monetary controls for the central bank, which in turn will act as the
instrument of controlling cyclical fluctuations.
11. Keynesian theory has played a vital role in the economic development of less-developed
countries.
12. He rejected the theory of wage-cut as a means of promoting full-employment.
13. Keynes’ theory has given rise to the importance of social accounting or national income
accounting.

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 UNIT 4
DEFINITION OF MONEY

1) Meaning of Money refers to the definition of money. Money is a token or item which acts as a
medium of exchange that has both legal and social acceptance with regards to making payment for
buying commodities or receiving services, as well as repayment of loans
2) Money refers both to currency, specifically a large number of currencies that circulate under the
legal tender status, and different types of financial deposit accounts, for example savings accounts,
demand deposits, as well as certificates of deposit.

Functions of Money
1) Money as a Medium of Exchange:
The function of money as a medium of exchange solves all the difficulties of barter system. There is
no necessity for a double coincidence of wants in the money economy. The man with cow who
wants to purchase cloth need not seek a cloth seller who wants a cow. He can sell his cow in the
market for money and then purchase cloth with the money obtained.
2) Money as a Measure of Value:
In money economy values of all commodities are expressed in terms of money. Money is like the
yard stick of cloth merchant, as yard-stick measures all varieties of cloth, money measures the value
of all varieties goods. This function of money makes transactions easy and also fair
3) Standard of Deferred Payment:
In a money economy the contracts are made for future payments terms of money instead of goods
and promise to repay the loan in money. In this way money is the standard of deferred payments.
This function stimulates all kinds of economic activities which depend on borrowed money.
4) Money as a Store of Value:
Goods cannot be stored because they are perishable. People receive their incomes in money form
and keep their savings in money form in banks. In this way, money is used to store value of
commodities.

Supply-Demand theory of money or Quantity theory of money

In monetary economics, the quantity theory of money states that money supply has a direct, proportional
relationship with the price level.
The determinants of money demand are infinite. In general, consumers need money to purchase goods and
services. The most important variable in determining money demand is the average price level within the
economy. If the average price level is high and goods and services tend to cost a significant amount of
money, consumers will demand more money. If, on the other hand, the average price level is low and goods
and services tend to cost little money, consumers will demand less money.

26
 Money Supply

High Low

↑ Price Level
Value of Money ↓

Money Demand
Low High

Low Quantity of Money  High

Figure: Determination of value of money

The value of money is ultimately determined by the intersection of the money supply, as controlled by the
central bank, and money demand, as created by consumers. The above figure depicts the money market in
a sample economy. The money demand curve slopes downward because as the value of money decreases,
consumers are forced to carry more money to make purchases because goods and services cost more
money.

Money Supply New Money Supply

High Low

↑ Price Level
Value of Money ↓

Money Demand
Low High

Low Quantity of Money  High

Figure: shift in the money market

The value of money, as revealed by the money market, is variable. A change in money demand or a change
in the money supply will yield a change in the value of money and in the price level. An increase in the
money supply is depicted in the Figure above.

Fisher’s Quantity Theory of Money or Price theory of money

The Quantity Theory was first developed by Irving Fisher in the inter-war years as is a basic theoretical
explanation for the link between money and the general price level. The quantity theory rests on what is

27
sometimes known as the Fisher identity or the equation of exchange. This is an identity which relates
total aggregate demand to the total value of output (GDP).

MV = PT
1. M is the money supply
2. V is the velocity of circulation of money
3. P is the general price level
4. Y is the real value of national output (i.e. real GDP)

The velocity of circulation represents the number of times that a unit of currency (for example a Rs.10
note) is used in a given period of time when used as a medium of exchange to buy goods and services. The
velocity of circulation can be calculated by dividing the money value of national output by the money
supply.

Assumptions in Fisher’s Quantity theory of money

Quantity Theory of Money by Fisher proceeds with the idea that price level is determined by the demand
for and supply of money. It is based upon the following assumptions.
1. Price level is to be measured over a period of time, it being the average of prices of all sale transactions
that take place during the said time period.
2. There are no credit sales in the market. All sales/purchase transactions are cash transactions..
3. Money is only a medium of exchange. Therefore, its demand is determined only because it is needed for
making current payments. It is not considered one of the alternative forms of assets for holding wealth.
Money is accepted by sellers so as to pay for their own purchases.
4. Each unit of money can change hands several times during the said time interval. The average number of
time money changes hands is termed its average velocity of circulation (V). Accordingly, total cash
payments during the year are always equal to the average quantity of money in circulation (M) multiplied
by its velocity (V), that is equal to MV.
5. Similarly, because there are no credit sales, all cash payments received during the year must be equal to
the volume of goods and services sold multiplied by the their respective prices. If, therefore, ‘T’ denotes the
aggregate volume of all items sold and ‘P’ stands for their average price, then total sales proceeds received
are equal to ‘P’.

Criticism of Fisher’s Quantity Theory of money

1. The price level (P) is wrongly assumed to be a passive factor: The price level P is not passive as
assumed by Fisher. In reality P may be active. P does influence T, because rising prices give profit
incentives to business expansion, T would increase. Thus, a rise in P may increase the volume of trade
which may cause an increase in the quantity of money and V.
2. The velocity of circulation of money (V) may not be a constant factor: Fisher regards V as
independent and constant. But, in practice V may vary with the volume of trade and price level, i.e., with P
and T. V is also affected by the actual and expected changes in M or money supply. Then, the effect of
changes in M may be neutralized by an opposite change in V. Sometimes, M being constant, V may increase,
causing the price level to rise. For instance, the hyperinflation in Germany in 1923 was more as a result of
the increase in the velocity of circulation rather than the increase in the money supply.
3. The assumption of full employment in unrealistic: A fundamental objection raised by Keynes
against the cash transactions approach is that it is based on the assumption of full employment, which is a
rare possibility in a modern society.

28
4. The theory neglects the role of interest rate: It is argued by critics like Mrs. Robinson that the
quantity theory cannot be regarded as an adequate theory of money because it does not take into account
the rate of interest.

Cambridge cash Balance Approach

The Cambridge equation formally represents the Cambridge cash-balance theory, an alternative
approach to the classical quantity theory of money. Both quantity theories, Cambridge and classical,
attempt to express a relationship among the amount of goods produced, the price level, amounts of money,
and how money moves. The Cambridge equation focuses on money demand instead of money supply. The
theories also differ in explaining the movement of money: In the classical version, associated with Irving
Fisher, money moves at a fixed rate and serves only as a medium of exchange while in the Cambridge
approach money acts as a store of value and its movement depends on the desirability of holding cash.
The Cambridge equation is : Md = k.P.Y

Keynes liquidity preference theory of money

Liquidity preference in macroeconomic theory refers to the demand for money, considered as liquidity.
The concept was first developed by John Maynard Keynes in his book The General Theory of Employment,
Interest and Money (1936) to explain determination of the interest rate by the supply and demand for
money. The demand for money as an asset was theorized to depend on the interest foregone by not holding
bonds. Instead of a reward for saving, interest in the Keynesian analysis is a reward for parting with
liquidity.
According to Keynes, demand for liquidity is determined by three motives:
1. The transactions motive: people prefer to have liquidity to assure basic transactions, for their
income is not constantly available. The amount of liquidity demanded is determined by the level of income:
the higher the income, the more money demanded for carrying out increased spending.
2. The precautionary motive: people prefer to have liquidity in the case of social unexpected
problems that need unusual costs. The amount of money demanded for this purpose increases as income
increases.
3. Speculative motive: people retain liquidity to speculate that bond prices will fall. When the
interest rate decreases people demand more money to hold until the interest rate increases, which would
drive down the price of an existing bond to keep its yield in line with the interest rate. Thus, the lower the
interest rate, the more money demanded (and vice versa).
The liquidity-preference relation can be represented graphically as a schedule of the money demanded at
each different interest rate. The supply of money together with the liquidity-preference curve in theory
interact to determine the interest rate at which the quantity of money demanded equals the quantity of
money supplied

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 UNIT-V
BANKING & CREDIT MANAGEMENT

CENTRAL BANK
A central bank, reserve bank, or monetary authority is a public institution that usually issues the
currency, regulates the money supply, and controls the interest rates in a country. Central banks often also
oversee the commercial banking system of their respective countries. In contrast to a commercial bank, a
central bank possesses a monopoly on printing the national currency, which usually serves as the nation's
legal tender. The primary function of a central bank is to provide the nation's money supply, but more
active duties include controlling interest rates, and acting as a lender of last resort to the banking sector
during times of financial crisis. It may also have supervisory powers, to ensure that banks and other
financial institutions do not behave recklessly or fraudulently.

What are functions of central bank?

1. Supervision of the banking system: Central bank supervises the banking system of the country.
Central may be responsible for banking system. They collect information from commercial bank and
take necessary decision by two ways- a) bank examine and b) bank regulation
2. Advising the government on monetary policy: The decision on monetary policy may be taken by
the central bank. Monetary policy refers to interest rates and money supply. The central bank will
corporate with the government on economic policy generally and will produce advice on monetary
policy and economic matters, including all the statistics.
3. Issue of banknotes: The central bank controls the issue of banknotes and coins. Most payment these
day do not involve cash but cheques, standing order, direct debit, credit cards and so on. Nevertheless,
cash is important as bank's cash holdings are a constraint on creation of credit, as we have seen.
4. Acting as banker to other banks: The Central bank will act as banker to the other banks in the
country. As well as holding accounts with international bodies like IMF World bank. It is a common
habit for the central bank to insist that the other banks hold non-interest bearing reserves with in
proportion to their deposit.
5. Acting as banker to government: Normally a central bank acts as the government's banker. It
receives revenues for Taxes and other income and pay out money for t6he government's expenditure.
Usually, it will not lend to the government but will help the government to borrow money by the sales
of its bill and bonds.
6. Raising money for the government: The government Treasury bill and bond markets are covered by
the central bank. While sometimes the treasury or ministry of finance handle

Reserve Bank of India (RBI)

The central bank of the country is the Reserve Bank of India (RBI). It was established in April 1935 with a
share capital of Rs. 5 crores on the basis of the recommendations of the Hilton Young Commission. The
share capital was divided into shares of Rs. 100 each fully paid which was entirely owned by private
shareholders in the begining. The Government held shares of nominal value of Rs. 2,20,000.

Reserve Bank of India was nationalised in the year 1949. The general superintendence and direction of the
Bank is entrusted to Central Board of Directors of 20 members, the Governor and four Deputy Governors,
one Government official from the Ministry of Finance, ten nominated Directors by the Government to give
representation to important elements in the economic life of the country, and four nominated Directors by
the Central Government to represent the four local Boards with the headquarters at Mumbai, Kolkata,
Chennai and New Delhi. Local Boards consist of five members each Central Government appointed for a

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term of four years to represent territorial and economic interests and the interests of co-operative and
indigenous banks.

The Reserve Bank of India Act, 1934 was commenced on April 1, 1935. The Act, 1934 (II of 1934) provides
the statutory basis of the functioning of the Bank.

The Bank was constituted for the need of following:

To regulate the issue of banknotes
To maintain reserves with a view to securing monetary stability and
To operate the credit and currency system of the country to its advantage.

Functions of Reserve Bank of India

The Reserve Bank of India Act of 1934 entrust all the important functions of a central bank the Reserve
Bank of India.

Bank of Issue - Under Section 22 of the Reserve Bank of India Act, the Bank has the sole right to issue bank
notes of all denominations. The distribution of one rupee notes and coins and small coins all over the
country is undertaken by the Reserve Bank as agent of the Government. The Reserve Bank has a separate
Issue Department which is entrusted with the issue of currency notes. The assets and liabilities of the Issue
Department are kept separate from those of the Banking Department. Originally, the assets of the Issue
Department were to consist of not less than two-fifths of gold coin, gold bullion or sterling securities
provided the amount of gold was not less than Rs. 40 crores in value. The remaining three-fifths of the
assets might be held in rupee coins, Government of India rupee securities, eligible bills of exchange and
promissory notes payable in India. Due to the exigencies of the Second World War and the post-war period,
these provisions were considerably modified. Since 1957, the Reserve Bank of India is required to maintain
gold and foreign exchange reserves of Ra. 200 crores, of which at least Rs. 115 crores should be in gold. The
system as it exists today is known as the minimum reserve system.

Banker to Government
The second important function of the Reserve Bank of India is to act as Government banker, agent and
adviser. The Reserve Bank is agent of Central Government and of all State Governments in India excepting
that of Jammu and Kashmir. The Reserve Bank has the obligation to transact Government business, via. to
keep the cash balances as deposits free of interest, to receive and to make payments on behalf of the
Government and to carry out their exchange remittances and other banking operations. The Reserve Bank
of India helps the Government - both the Union and the States to float new loans and to manage public debt.
The Bank makes ways and means advances to the Governments for 90 days. It makes loans and advances to
the States and local authorities. It acts as adviser to the Government on all monetary andbanking matters.

Bankers' Bank and Lender of the Last Resort

The Reserve Bank of India acts as the bankers' bank. According to the provisions of the Banking Companies
Act of 1949, every scheduled bank was required to maintain with the Reserve Bank a cash balance
equivalent to 5% of its demand liabilites and 2 per cent of its time liabilities in India. By an amendment of
1962, the distinction between demand and time liabilities was abolished and banks have been asked to
keep cash reserves equal to 3 per cent of their aggregate deposit liabilities. The minimum cash
requirements can be changed by the Reserve Bank of India.

The scheduled banks can borrow from the Reserve Bank of India on the basis of eligible securities or get
financial accommodation in times of need or stringency by rediscounting bills of exchange. Since

31
commercial banks can always expect the Reserve Bank of India to come to their help in times of banking
crisis the Reserve Bank becomes not only the banker's bank but also the lender of the last resort.

Controller of Credit
The Reserve Bank of India is the controller of credit i.e. it has the power to influence the volume of credit
created by banks in India. It can do so through changing the Bank rate or through open market operations.
According to the Banking Regulation Act of 1949, the Reserve Bank of India can ask any particular bank or
the whole banking system not to lend to particular groups or persons on the basis of certain types of
securities. Since 1956, selective controls of credit are increasingly being used by the Reserve Bank.

The Reserve Bank of India is armed with many more powers to control the Indian money market. Every
bank has to get a licence from the Reserve Bank of India to do banking business within India, the licence
can be cancelled by the Reserve Bank of certain stipulated conditions are not fulfilled. Every bank will have
to get the permission of the Reserve Bank before it can open a new branch. Each scheduled bank must send
a weekly return to the Reserve Bank showing, in detail, its assets and liabilities. This power of the Bank to
call for information is also intended to give it effective control of the credit system. The Reserve Bank has
also the power to inspect the accounts of any commercial bank.

As supreme banking authority in the country, the Reserve Bank of India, therefore, has the following
powers:
(a) It holds the cash reserves of all the scheduled banks.
(b) It controls the credit operations of banks through quantitative and qualitative controls.
(c) It controls the banking system through the system of licensing, inspection and calling for information.
(d) It acts as the lender of the last resort by providing rediscount facilities to scheduled banks.

Custodian of Foreign Reserves

The Reserve Bank of India has the responsibility to maintain the official rate of exchange. According to the
Reserve Bank of India Act of 1934, the Bank was required to buy and sell at fixed rates any amount of
sterling in lots of not less than Rs. 10,000. The rate of exchange fixed was Re. 1 = sh. 6d. Since 1935 the
Bank was able to maintain the exchange rate fixed at lsh.6d. though there were periods of extreme pressure
in favour of or against the rupee. After India became a member of the International Monetary Fund in 1946,
the Reserve Bank has the responsibility of maintaining fixed exchange rates with all other member
countries of the I.M.F.

Besides maintaining the rate of exchange of the rupee, the Reserve Bank has to act as the custodian of
India's reserve of international currencies. The vast sterling balances were acquired and managed by the
Bank. Further, the RBI has the responsibility of administering the exchange controls of the country.

Supervisory functions
In addition to its traditional central banking functions, the Reserve bank has certain non-monetary
functions of the nature of supervision of banks and promotion of sound banking in India. The Reserve Bank
Act, 1934, and the Banking Regulation Act, 1949 have given the RBI wide powers of supervision and control
over commercial and co-operative banks, relating to licensing and establishments, branch expansion,
liquidity of their assets, management and methods of working, amalgamation, reconstruction, and
liquidation. The RBI is authorised to carry out periodical inspections of the banks and to call for returns
and necessary information from them. The nationalisation of 14 major Indian scheduled banks in July 1969
has imposed new responsibilities on the RBI for directing the growth of banking and credit policies
towards more rapid development of the economy and realisation of certain desired social objectives. The

32
supervisory functions of the RBI have helped a great deal in improving the standard of banking in India to
develop on sound lines and to improve the methods of their operation.

Promotional functions
With economic growth assuming a new urgency since Independence, the range of the Reserve Bank's
functions has steadily widened. The Bank now performs a varietyof developmental and promotional
functions, which, at one time, were regarded as outside the normal scope of central banking. The Reserve
Bank was asked to promote banking habit, extend banking facilities to rural and semi-urban areas, and
establish and promote new specialised financing agencies. Accordingly, the Reserve Bank has helped in the
setting up of the IFCI and the SFC; it set up the Deposit Insurance Corporation in 1962, the Unit Trust of
India in 1964, the Industrial Development Bank of India also in 1964, the Agricultural Refinance
Corporation of India in 1963 and the Industrial Reconstruction Corporation of India in 1972. These
institutions were set up directly or indirectly by the Reserve Bank to promote saving habit and to mobilise
savings, and to provide industrial finance as well as agricultural finance. As far back as 1935, the Reserve
Bank of India set up the Agricultural Credit Department to provide agricultural credit. But only since 1951
the Bank's role in this field has become extremely important. The Bank has developed the co-operative
credit movement to encourage saving, to eliminate moneylenders from the villages and to route its short
term credit to agriculture. The RBI has set up the Agricultural Refinance and Development Corporation to
provide long-term finance to farmers.

What Is Credit Creation?

One of the important functions of commercial bank is the creation of credit. Credit creation is the multiple
expansions of banks demand deposits. It is an open secret now that banks advance a major portion of their
deposits to the borrowers and keep smaller parts of deposits to the customers on demand. Even then the
customers of the banks have full confidence that the depositor's lying in the banks are quite safe and can be
withdrawn on demand. The banks exploit this trust of their clients and expand loans by much more time
than the amount of demand deposits possessed by them. This tendency on the part of the commercial
banks to expand their demand deposits as a multiple of their excess cash reserve is called creation of credit.
The single bank cannot create credit. It is the banking system as a whole which can expand loans by many
times of its excess cash reserves. Further, when a loan is advanced to an individuals or a business concern,
it is not given in cash. The bank opens a deposit account in the name of the borrower and allows him to
draw upon the bank as and when required. The loan advanced becomes the gain of deposit by some other
bank. Loans thus make deposits and deposits make loans.

What are the objectives of credit control by central banks?

The central bank makes efforts to control the expansion or contraction of credit in order to keep it at the
required level with a view to achieving the following ends.
1) To save Gold Reserves: The central bank adopts various measures of credit control to safe guard the
gold reserves against internal and external drains.
2) To achieve stability in the Price level: Frequently changes in prices adversely affect the economy.
Inflationary and deflationary trends need to be prevented. This can be achieved by adopting a judicious
of credit control.
3) To achieve stability in the Foreign Exchange Rate: Another objective of credit control is to achieve the
stability of foreign exchange rate. If the foreign exchange rate is stabilized, it indicates the stable
economic conditions of the country.
4) To meet Business Needs: According to Burgess, one of the important objectives of credit control is the
"Adjustment of the volume of credit to the volume of Business" credit is needed to meet the
requirements of trade an industry. So by controlling credit central bank can meet the requirement

33
The RBI adopt two methods to control credit in modern times for regulating bank advances. They
are as follows:-

(A) Quantitative or General Credit Control

This method aims to regulate the amount of bank advance. This method includes:
(a) Bank Rate
(b) Open Market Operation
(c) Variables Reserves Ratio

(a) Bank Rate: It is the rate at which central bank discounts the securities of commercial banks or advance
loans to commercial banks. This rate is the minimum and it affects both cost and availability of credit. Bank
rate is different from market rate. Market rate is the rate of discount prevailing in the money market among
other lending institutions. Generally bank rate is higher than the market rate. If the bank rate is changed all
the other rates normally change at the same direction. A central bank control credit by manipulating the
bank rate. If the central bank raise the bank rate to control credit, the market discount rate and other
lending rates in the money will go up. The cost of credit goes up and demand for credit goes down. As a
result, the volume of bank loans and advances is curtailed. Thus raise in bank rate will contract credit.

(b) Open Market Operation: It refers to buying and selling of Government securities by the central bank
in the open market. this method of credit control become very popular after the 1st World War. During
inflation, the bank will securities and during depression, it will purchase securities from the public and
financial institutions. The RBI is empowered to buy and sell government securities from the public and
financial institutions. The RBI is empowered to buy and sell government securities, treasury bills and other
approved securities. The central bank uses the weapon to overcome seasonal stringency in funds during
the slack season. When the central bank sells securities, they are purchased by the commercial banks and
private individuals. So money supply is reduced in the economy and there is contraction in credit.
When the securities are purchased by the central bank, money goes to the commercial banks and the
customers. SO money supply is increased in the economy and there is more demand for credit.
Thus open market operation is one of the superior instrument of credit control. But for achieving an ideal
result both Bank Rate and Open Market Operation must be used simultaneously.

(c) Variable Reserve Ratio (VRR): This is a new method of credit control adopted by central bank.
Commercial banks keep cash reserves with the central bank to maintain for the purpose of liquidity and
also to provide the means for credit control. The cash reserve is also called minimum legal reserve
requirement. The percentage of this ratio can be changed legally by the central bank. The credit creation of
commercial banks depends on the value of cash reserves. If the value of reserve ratio increase and other
things remain constant, the power of credit creation by the commercial bank is decreased and vice versa.
Thus by varying the reserve ratio, the lending capacity of commercial banks can be affected.

(B) Qualitative or Selective Control Method:

It is also known as qualitative credit control. This method is used to control the flow of credit to
particular sectors of the economy. The direction of credit is regulated by the central bank. This method is
used as a complementary to quantitative credit control discourage the flow of credit to unproductive
sectors and speculative activities and also to attain price stability. The main instruments used for this
purpose are:

(1) Varying margin requirements for certain bank: While lending commercial banks accept securities,
deduct a certain margin from the market value of the security. This margin is fixed by the central bank and

34
adjust according to the requirements. This method affect the demand for credit rather than the quantity
and cost of credit. This method is very effective to control supply of credit for speculative dealing in the
stock exchange market. It also helps for checking inflation when the margin is raised. If the margin is fixed
as 30%, the commercial banks can lend up to 70% of the market value of security. This method has been
used by RBI since 1956 with suitable modifications from time to time as per the demand and supply of
commodities.

(2) Regulation of consumer's credit: Apart from trade and industry a great amount of credit is given to
the consumers for purchasing durable goods also. RBI seeks to control such credit in the following ways:
(a) by regulating the minimum down payments on specific goods.
(b) by fixing the coverage of selective consumers durable goods.
(c) by regulating the maximum maturities on all installment credit and
(d) by fixing exemption costs of installment purchase of specific goods.

(3) Control through Directives: Under this system, the central bank can issue directives for the credit
control. There may be a written or oral voluntary agreement between the central bank and commercial
banks in this regard. Sometimes the commercial banks do not follow these directives of the RBI.

(4) Rationing of credit: The amount of credit to be granted is fixed by the central bank. Credit is rationed
by limiting the amount available to each commercial bank. The RBI can also restrict the discounting of bills.
Credit can also be rationed by the fixation of ceiling for loans and advances.

(5) Direct Action: It is an extreme step taken by the RBI. It involves refusal by RBI to extend credit
facilities, denial of permission to open new branches etc. RBI also gives wide publicity about the erring
banks to create awareness amongst the public.

(6) Moral suasion: RBI uses persuasion to influence lending activities of banks. It sends letters to banks
periodically, advising them to follow sound principles of banking. Discussions are held by the RBI with
banks to control the flow of credit to the desired sectors.

Inflation & deflation of money

Demand-pull inflation refers to the idea that the economy actual demands more goods and services than
available. This shortage of supply enables sellers to raise prices until an equilibrium is put in place
between supply and demand. The cost-push theory , also known as "supply shock inflation", suggests that
shortages or shocks to the available supply of a certain good or product will cause a ripple effect through
the economy by raising prices through the supply chain from the producer to the consumer. You can
readily see this in oil markets. When OPEC reduces oil supply, prices are artificially driven up and result in
higher prices at the pump.

Money supply plays a large role in inflationary pressure as well. Monetarist economists believe that if the
Federal Reserve does not control the money supply adequately, it may actually grow at a rate faster than
that of the potential output in the economy, or real GDP. The belief is that this will drive up prices and
hence, inflation. Low interest rates correspond with a high levels of money supply and allow for more
investment in big business and new ideas which eventually leads to unsustainable levels of inflation as
cheap money is available. The credit crisis of 2007 is a very good example of this at work.

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Inflation can artificially be created through a circular increase in wage earners demands and then the
subsequent increase in producer costs which will drive up the prices of their goods and services. This will
then translate back into higher prices for the wage earners or consumers. As demands go higher from each
side, inflation will continue to rise.

Effects of Inflation
The most immediate effects of inflation are the decreased purchasing power of the dollar and its
depreciation. Depreciation is especially hard on retired people with fixed incomes because their money
buys a little less each month. Those not on fixed incomes are more able to cope because they can simply
increase their fees. A second destabilizing effect is that inflation can cause consumers and investors to
change their speeding habits. When inflation occurs, people tend to spend less meaning that factories have
to lay off workers because of a decline in orders. A third destabilizing effect of inflation is that some people
choose to speculate heavily in an attempt to take advantage of the higher price level. Because some of the
purchases are high-risk investments, spending is diverted from the normal channels and some structural
unemployment may take place. Finally, inflation alters the distribution of income. Lenders are generally
hurt more than borrowers during long inflationary periods which means that loans made earlier are repaid
later in inflated dollars

Deflation
In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when
the annual inflation rate falls below 0% (a negative inflation rate). This should not be confused with
disinflation, a slow-down in the inflation rate (i.e. when inflation declines to lower levels). Inflation reduces
the real value of money over time; conversely, deflation increases the real value of money – the currency of
a national or regional economy. This allows one to buy more goods with the same amount of money over
time.

Causes of Inflation
An increase in the general level of prices implies a decrease in the purchasing power of the currency. That
is, when the general level of prices rises, each monetary unit buys fewer goods and services. The effect of
inflation is not distributed evenly in the economy, and as a consequence there are hidden costs to some and
benefits to others from this decrease in the purchasing power of money. For example, with inflation,
lenders or depositors who are paid a fixed rate of interest on loans or deposits will lose purchasing power
from their interest earnings, while their borrowers benefit. Individuals or institutions with cash assets will
experience a decline in the purchasing power of their holdings. Increases in payments to workers and
pensioners often lag behind inflation, especially for those with fixed payments.

Negative Effects of Inflation

High or unpredictable inflation rates are regarded as harmful to an overall economy. They add
inefficiencies in the market, and make it difficult for companies to budget or plan long-term. Inflation can
act as a drag on productivity as companies are forced to shift resources away from products and services in
order to focus on profit and losses from currency inflation.[11] Uncertainty about the future purchasing
power of money discourages investment and saving.[31] And inflation can impose hidden tax increases, as
inflated earnings push taxpayers into higher income tax rates unless the tax brackets are indexed to
inflation.
With high inflation, purchasing power is redistributed from those on fixed nominal incomes, such as some
pensioners whose pensions are not indexed to the price level, towards those with variable incomes whose
earnings may better keep pace with the inflation.[11] This redistribution of purchasing power will also occur
between international trading partners. Where fixed exchange rates are imposed, higher inflation in one

36
economy than another will cause the first economy's exports to become more expensive and affect the
balance of trade. There can also be negative impacts to trade from an increased instability in currency
exchange prices caused by unpredictable.

The effects of deflation are:

1. Decreasing nominal prices for goods and services
2. Increasing real value of cash money and all monetary items
3. Discourages bank savings and decreases investment
4. Enriches creditors at the expenses of debtors
5. Benefits fixed-income earners
6. Recessions and unemployment

Deflation is generally regarded negatively, as it causes a transfer of wealth from borrowers and holders of
illiquid assets, to the benefit of savers and of holders of liquid assets and currency. In this sense it is the
opposite of inflation, which is similar to taxing currency holders and lenders (savers) and using the
proceeds to subsidize borrowers. Thus inflation may encourage short term consumption. In modern
economies, deflation is usually caused by a drop in aggregate demand, and is associated with recession and
(more rarely) long term economic depressions.

While an increase in the purchasing power of one's money sounds beneficial, it amplifies the sting of debt.
This is because after some period of significant deflation, the payments one is making in the service of a
debt represent a larger amount of purchasing power than they did when the debt was first incurred.
Consequently, deflation can be thought of as a phantom amplification of a loan's interest rate.

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