EFM- Module 6

Money Supply and Value of Money

Definition: The total stock of money circulating in an economy is the

money supply. The circulating money involves the currency, printed
notes, money in the deposit accounts and in the form of other liquid
assets.
Valuation and analysis of the money supply help the
economist and policy makers to frame the policy or to alter the
existing policy of increasing or reducing the supply of money.
Link between value of money and price of goods
Value of money and price of goods move in opposite
direction. Higher the price lower is the value of money.

How do the price of goods rise?

If supply of money increases people will have more money

in hand, demand increases, supply of goods remaining the
same. In this situation the price of goods increases.

When supply of goods decreases demand remaining the

same. Reduction in supply increases the price.
Inflation
Inflation refers to the rise in the prices of most goods
and services of daily or common use, such as food,
clothing, housing, recreation, transport, consumer staples,
etc. Inflation measures the average price change in a basket
of commodities and services over time.

The opposite and rare fall in the price index of this basket
of items is called ‘deflation’.

As price of goods rises value of money falls. Economists

categorize inflation into 2 broad categories
1. Price inflation
2. Money inflation
 Price inflation is the effect of money inflation. If money
supply increases price inflation occurs. There are different
causes for increase in money supply of which printing of
additional currency is the main cause.
Printing of additional currency is demanded by
government to meet its needs of expenditure or aids from the
world bank.
Other sources of money supply are foreign exchange
inflow, FDI, FII’s and other income from abroad.

“Inflation occurs when price of goods increases or when money

becomes less valuable relative to those goods”
Causes of inflation
 Excess money Supply
 Demand pull inflation
 Cost push inflation
 Obsolete technology
 Scarcity of resources
 Natural calamities
Demand Pull Inflation
When aggregate demand level increases due to any
reason and supply of output is unable to match this demand,
then inflationary pressure built in is known as Demand Pull
Inflation. That means demand pulls prices up.
This may occur due to
Increase in disposable income
Increase in aggregate spending
Increase in population
Cost Push Inflation
Cost Push Inflation occurs when demand is unchanged
but still prices rise. This happens due to shortage of supply.
If producers produce same level of output even when
input prices increases, total cost increases and hence price of
goods/services increase. Here, prices are pushed by cost

Inflationary Gap
Inflationary gap is the result of excess demand. It may be
defined as the excess of planned levels of expenditure over the
available output at base prices.
When money income in the hands of people exceeds the
supply of goods and services, a gap is created between demand
and supply which results in inflation.
Price rise due to gap between demand and supply is
called Inflationary Gap
Monetary Policy
Monetary policy is the process where central bank controls
the supply of money by controlling interest rates to stabilize the price
and achieve high economic growth
These policies are implemented through different tools,
including the adjustment of the interest rates, purchase or sale of
government securities, and changing the amount of cash circulating in
the economy. The central bank is responsible for formulating these
policies.
 Objectives of Monetary Policy
The primary objective of monetary policy is to maintain
price stability while keeping in mind the objective of growth.
Price stability is a necessary precondition to sustainable growth.
The other main objectives of monetary policies are the
management of inflation or unemployment, and maintenance
of currency exchange rates, etc.
1. Inflation
Monetary policies can target inflation levels. A low level of
inflation is considered to be healthy for the economy. If inflation
is high, a contractionary policy can address this issue.
2. Unemployment
Unemployment leads to wastage of potential output. By
providing concessional loans to productive sectors, small and
medium entrepreneurs, special loan schemes for unemployed
youth, monetary policy promotes employment.
Economic Growth
Monetary policy can promote faster economic growth by
making credit cheaper and more readily available. Industry and
agriculture require two types of credit—short-term credit to meet
working capital needs and long-term credit to meet fixed capital
needs.
The need for these two types of credit can be met through
commercial banks and development banks. Easy availability of credit
at low rates of interest stimulates investment or expansion of
society’s production capacity. This in its turn, enables the economy to
grow faster than before.
Exchange Rate Stability
In an ‘open economy’—that is, one whose borders are open to goods,
services, and financial flows— the exchange-rate system is also a
central part of monetary policy. In order to prevent large depreciation
or appreciation of the rupee in terms of the US dollar and other
foreign currencies under the present system of floating exchange rate
the central bank has to adopt suitable monetary measures.
To Promote saving and Investment
To control Business Cycles
Maintain equilibrium in Balance of Payments
 Instruments of Monetary Policy
The monetary policy refers to a regulatory policy
whereby the central bank maintains its control over the
supply of money to achieve the general economic goals.
Main instruments of the monetary policy are:
1. Cash Reserve Ratio
2. Statutory Liquidity Ratio
3. Bank Rate
4. Repo Rate
5. Reverse Repo Rate
6. Open Market Operations.
Cash Reserve Ratio(CRR)
Cash reserve ratio is a certain percentage of bank
deposits which banks are required to keep with RBI in the
form of reserves or balances. The higher the CRR with the
RBI, the lower will be the liquidity in the system, and vice
versa. Current CRR is 4.5 %
Statutory liquidity ratio (SLR)
Every financial institution has to maintain a certain
quantity of liquid assets with themselves at any point of
time of their total time and demand liabilities. These assets
have to be kept in non cash form such as G-secs precious
metals, approved securities like bonds. The ratio of the
liquid assets to time and demand liabilities is termed as
the Statutory liquidity ratio.
Current SLR is 18%
Bank Rate
The bank rate, also known as the discount rate, is
the rate of interest charged by the central bank on the
loans they have extended to commercial banks and other
financial institutions is called “Bank Rate”. In this case,
there is no repurchasing agreement signed, no securities
sold or collateral involved.
Banks borrow funds from the central bank and lends
the money to their customers at a higher interest rate,
thus, making profits. Bank Rate is usually higher than Repo
Rate as it is an important tool to control liquidity.
Current Bank Rate is 6.75%
Repo Rate
When we experience a financial shortfall, we
approach the bank for loans. Likewise, when banks fall
short of funds, they approach the central bank for financial
assistance. Repo Rate is the rate at which the country’s
central bank, which is RBI in India, lends money to
commercial banks during financial crisis.
In other words, commercial banks borrow money
from the Reserve Bank of India by selling securities or
bonds with an agreement to repurchase the securities on a
certain date at a predetermined price. The rate of interest
charged by the central bank on the cash borrowed by
commercial banks is called the “Repo Rate”.
Current Repo Rate is 6.5%
Reverse Repo Rate
The reverse repo rate is the rate at which RBI borrows money
from the commercial banks.
For instance, when banks generate excess funds, they may
deposit the money in the central bank. This is a much safer approach
when compared to lending it to other companies or account holders.
So, the interest earned on the deposited funds is known as the
reverse repo rate.
As an example, let’s assume the reverse repo rate is 5% p.a. A
commercial bank has deposited Rs.10,000 in the central bank. This
means, the commercial bank will earn Rs.500 p.a. as interest.
This is another financial instrument used by the RBI to control
the supply of money in the nation. In case the RBI is falling short on
money, they can always ask commercial banks to pitch in with funds
and offer them great reverse repo rates in return.
Current Reverse Repo Rate is 3.35%
Open Market Operations
The sale and purchase of security in the long run/short run by
the RBI in the money market is known as open market operations.
This is a popular instrument of the RBI's monetary policy.
To influence the term and structure of the interest rate and to
stabilize the market for government securities, etc., the RBI uses
OMO, and this operation is also used to wipe out the shortage of
money in the money market.
If RBI sells securities in the money market, private and
commercial banks and even individuals buy it. This leads to a
reduction in the existing money supply as money gets transferred
from commercial banks to the RBI. On the other hand, when RBI buys
securities from the commercial banks, the commercial banks that sell
receive the amount they had invested in RBI before.
 Fiscal Policy
Fiscal policy is defined as the policy under which the
government uses the instrument of taxation, public spending and
public borrowing to achieve various objectives of economic policy.
It is the policy of government spending and taxation to achieve
sustainable growth.

The government has two variables to influence fiscal policy, namely

Taxation- regulating which the government increases or decreases

the disposable cash in the hands of the public.

Government spending- using which the government invests in

public infrastructural works and other social welfare schemes that
directly or indirectly influence the state of the economy.
 Objectives of Fiscal Policy
• Economic Growth
• Economic stabilization
• Full Employment
• Balance of payment Equilibrium
• Social Justice or Equality in the Distribution of Income and
Wealth
• Mobilization of resources
Economic Growth
Economic growth means rise in real national income as well as
per capita real income over time. Less developed and poor countries
suffer from the vicious circle of poverty and to break this vicious circle a
large dose of investment (big push) is necessary. Government can directly
interfere on economic activities and design fiscal policy to raise the level
of savings and to reduce potential consumption of the people.
Economic stabilization
In capitalist countries economic activities fluctuate over time and
these economies suffer from the problem of business cycles. To stabilize
the economy, i.e. to overcome recession (business downswing) and
control inflation (business upswing and over expansion) in the economy
fiscal policy may be regarded as an important instrument. At the time of
recession the government increases its expenditure or cuts down taxes or
adopts a suitable combination of both .On the other hand to control
inflation or business upswing the government cuts down its expenditure
or raises taxes.
Full Employment
In an economy those who are willing to work at the going
wage rate but do not get job are called involuntarily unemployed. In
a situation of full employment all those who are willing to work get
jobs and all are absorbed. If there is unemployment in an economy,
the government may adopt various expansionary measures for
increasing income and employment. There are various ways of
achieving this goal.
Mobilization of resources
Mobilization of resources is one of the most important
objectives of fiscal policy. It is a great tool in the hand of developing
countries like India. It is of utmost importance to increase the rate
of the investment and capital formation so as to accelerate the rate
of economic growth in the country. Fiscal measures like taxation
and public expenditure programme can help in mobilizing resources
from unproductive to productive channel.
Balance of Payment Equilibrium
When a country is engaged in international trade then the
country can get money (foreign currency) by exporting goods and
services and the country spends money for importing goods and services
from foreign countries .The difference between the value of exports and
imports is known as balance of trade and if it is added to the capital
account, then it is called balance of payment. If the value of exports is
less than value of imports then there will be a deficit in trade balance
and surplus if opposite happens.
In particular if a country has a deficit in trade balance, then to
correct such deficit the government should encourage exports and
discourage imports. For doing this, the government can grant different
types of benefits and exemptions to exporters, and impose hardships on
imports. In this way by increasing exports and decreasing imports the
problem of deficit in trade balance can be corrected and equilibrium in
balance of payment can be achieved.
Social Justice or Equality in the Distribution of Income and
Wealth:
A welfare state can provide social justice by giving
equitable distribution of income and wealth. Fiscal policy means
should be designed in such a manner that the distribution of
income and wealth will move in favors of the poor and against
the rich.
Thus, fiscal policy insists on the programmes like free
medical care, free education, old age pension scheme, widow
pension scheme and other social security measures to provide
social justice to the society. Public expenditure, particularly
grants and subsidies to poor helps in redistributing income from
the rich to the poorer section of the society.
Budget: The government budget or the revenue and expenditure
process of the government (either balanced or unbalanced) can be used
effectively to maintain stability and economic growth.
Taxation: It is also a powerful instrument of fiscal policy by means of
which the government can directly affect disposable income,
consumption, investment of the people and hence aggregate demand of
the economy. The government can encourage or discourage economic
growth and can combat inflationary and deflationary tendencies of the
economy by applying suitable tax policies.
Public Expenditure: Public expenditure is that expenditure incurred by
the government to satisfy those common wants which the people in
their individual capacity are unable to satisfy efficiently. It thus tends to
satisfy collective social wants. The appropriate variation in public
expenditure can have more direct effect upon the level of economic
activity than even taxes. It will have a multiple effect upon income,
employment and output. Hence by increasing or decreasing public
expenditure the fluctuations in economic activities can be checked
effectively.
Public Debt: Public borrowing or public debt is nothing but loans
taken by the government (both from internal and external
sources) when current revenues fall short of public expenditures.
The instruments of public borrowing are in the form of various
types of government bonds and securities. Public debt is a very
powerful instrument to fight against deflation.
It also brings about economic stability and full employment
in an economy. By means of public debt the government can meet
unprecedented expenses during War, natural calamities and
associated relief and rehabilitation works. In developing
economies it is the most important source of development
finance.