3.5 - The Supply of Money: Various Measures
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Functions of Money
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Today we’ll dive into the functions of money. Money serves three key roles: it is a medium of exchange, a unit of account, and a store of value. Can anyone explain what that means?
Money as a medium of exchange means it helps us trade goods without the need for barter.
Exactly! Barter requires a double coincidence of wants. With money, you can sell your goods for cash and then buy what you want. How about the unit of account?
It means we can price items using money, like saying a watch costs Rs. 500.
Correct! It provides a standard for measuring and comparing value. What about the store of value?
It allows us to save wealth for future use without losing value.
Great summary! Remember, money's functions are crucial for a smooth-functioning economy. If we didn’t have money, trading would be an inefficient mess!
Demand for Money
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Next, let's talk about the demand for money. Why do you think people want to hold money instead of spending it?
To use it for transactions later or for emergencies!
Exactly, it's for convenience and security! The demand for money increases with income. Can someone tell me how interest rates affect money demand?
When interest rates are high, people prefer to invest rather than hold onto cash because they can earn more!
Perfect! So, the higher the interest rate, the lower the demand for holding money. Let’s summarize: As income rises, demand for money rises; as interest rates rise, demand for money falls.
Supply of Money
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Now let's examine the supply of money. What components are included in the money supply?
Currency notes, coins, and bank deposits, right?
Exactly! In India, we measure money supply as M1, M2, M3, and M4. Who can tell me what M1 comprises?
M1 includes currency and demand deposits!
Right! It's the most liquid form of money. M3 is broader and includes time deposits too. This helps us understand how much money is truly circulating in the economy.
Central Bank's Role
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The central bank plays a crucial role in regulating the money supply. Can someone tell me what the Reserve Bank of India's main functions are regarding money supply?
It issues currency and controls the money supply using tools like the CRR and bank rate.
Great answer! The Cash Reserve Ratio ensures banks keep a fraction of deposits as reserves, which limits how much they can lend. What about open market operations?
It’s when the central bank buys or sells government securities to influence money supply.
Exactly! These tools help maintain economic stability and control inflation. Remember, the central bank's actions are vital for a robust financial system.
Introduction & Overview
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Quick Overview
Standard
The section outlines the role of money in modern economies, explaining its fundamental functions as a medium of exchange, unit of account, and store of value. It discusses how demand for money is influenced by income and interest rates and details the different measures of money supply, highlighting the roles of the central bank and commercial banks in money creation.
Detailed
The Supply of Money: Various Measures
In modern economies, money is essential for facilitating transactions. This section outlines the critical functions of money, which include being a medium of exchange (making trade easier), a unit of account (providing a standard measurement of value), and a store of value (allowing wealth to be preserved).
Money eliminates the inefficiencies of barter systems, which require a double coincidence of wants, making transactions cumbersome. As the economy grows, monetary transactions become vital. The demand for money increases with income and decreases at higher interest rates since individuals are motivated to earn interest rather than hold cash.
Furthermore, the section explains how the supply of money encompasses various forms, including currency and bank deposits. Measures of money supply are categorized as narrow money (M1 and M2) and broad money (M3 and M4), each representing different liquidity levels in the economy. The central bank, such as the Reserve Bank of India, plays a vital role as the issuer of currency and the regulator of money supply, employing tools such as reserve ratios and open market operations. This dynamic creates a complex system where banks can create money through lending, providing a multiplier effect to the overall money supply.
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Introduction to Money Supply
Chapter 1 of 4
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Chapter Content
In a modern economy, money consists mainly of currency notes and coins issued by the monetary authority of the country. In India, currency notes are issued by the Reserve Bank of India (RBI), which is the monetary authority in India. However, coins are issued by the Government of India.
Detailed Explanation
Money is vital for any economy as it serves as a medium for transactions. In modern economies, money primarily consists of physical forms like currency notes and coins. In India, the RBI is responsible for issuing currency notes, while coins come from the Government of India. This distinction is important as it highlights the role of central authority in controlling what is considered legal money.
Examples & Analogies
Think of money like a well-organized store. The RBI is like the manager who decides what items (currency) are available for customers (the public) to use for their purchases. Just as customers trust the store to provide quality products, people trust the RBI to issue reliable currency.
Demand Deposits and Time Deposits
Chapter 2 of 4
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Apart from currency notes and coins, the balance in savings or current account deposits held by the public in commercial banks is also considered money since cheques drawn on these accounts are used to settle transactions. Such deposits are called demand deposits as they are payable by the bank on demand from the account-holder. Other deposits, e.g. fixed deposits, have a fixed period to maturity and are referred to as time deposits.
Detailed Explanation
Money isn't just physical cash; it also includes what people have in their bank accounts. When individuals have funds in checking or savings accounts, they can easily access this money whenever they need it. These funds are known as demand deposits. In contrast, funds in fixed deposits are less accessible since they are locked in for a specific period. Understanding the different types of deposits helps us grasp how money functions in the economy.
Examples & Analogies
Consider demand deposits like water in a tap that you can turn on whenever you are thirsty. You can access that water immediately. Time deposits are like ice cubes kept in the freezer. They can be turned into water (money) later but only after waiting for some time. While the water is readily available, the ice requires planning to use.
Legal Tender and Fiat Money
Chapter 3 of 4
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Chapter Content
The value of the currency notes and coins is derived from the guarantee provided by the issuing authority of these items. Every currency note bears on its face a promise from the Governor of RBI that if someone produces the note to RBI, or any other commercial bank, RBI will be responsible for giving the person purchasing power equal to the value printed on the note. Currency notes and coins are therefore called fiat money. They do not have intrinsic value like a gold or silver coin. They are also called legal tenders as they cannot be refused by any citizen of the country for settlement of any kind of transaction.
Detailed Explanation
Fiat money is currency that a government has declared to be legal tender, meaning it must be accepted if offered in payment of debt. Its value comes not from physical commodities but from trust in the issuer, in this case, the RBI. This is important to understand because it highlights how societal acceptance and governmental backing create value in money.
Examples & Analogies
Imagine a club with exclusive membership cards. The cards themselves are not valuable, but the promise from the club to provide services makes them valuable. Similarly, paper currency holds value because the government backs it, allowing it to be used for trade and transactions.
Measures of Money Supply
Chapter 4 of 4
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Money supply, like money demand, is a stock variable. The total stock of money in circulation among the public at a particular point of time is called money supply. RBI publishes figures for four alternative measures of money supply, viz. M1, M2, M3 and M4. They are defined as follows: M1 = CU + DD, M2 = M1 + Savings deposits with Post Office savings banks, M3 = M1 + Net time deposits of commercial banks, M4 = M3 + Total deposits with Post Office savings organisations (excluding National Savings Certificates).
Detailed Explanation
Money supply is a stock variable, meaning it shows the total amount of money available at any given point in time. The RBI categorizes money supply into different measures: M1 is the most liquid and includes currency and demand deposits. M2 includes M1 plus some savings deposits, while M3 adds time deposits, making it broader. M4 includes M3 and additional deposits from the Post Office. Understanding these measures gives insights into how money circulates in the economy.
Examples & Analogies
Think of M1, M2, M3, and M4 as different levels of a water reservoir. M1 is the top layer of water that is most accessible for use immediately. M2 adds another layer of water that can be accessed with some effort, while M3 and M4 include water that takes more time to access but is still part of the overall reservoir.
Key Concepts
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Medium of Exchange: Money serves as a facilitator of trade.
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Unit of Account: Money provides a standard measure of value.
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Store of Value: Money allows individuals to store wealth for future use.
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Demand for Money: Affected by income levels and interest rates.
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Supply of Money: Includes various forms of currency and bank deposits.
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Narrow vs. Broad Money: Different definitions of money supply based on liquidity.
Examples & Applications
In an economy with only barter, two people may struggle to trade without mutual wants, whereas money enables smooth transactions.
A farmer sells crops for Rs. 1000 and uses that money to buy new farming tools, illustrating the medium of exchange function.
Memory Aids
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Rhymes
Money is like a key, unlocking trades you see; without it, barter's tough, making exchanges rough.
Stories
Imagine a village where villagers trade with rice for shoes. One day, they decide to use colorful shells as money; suddenly, trading becomes easier, and they can save their rice for later!
Memory Tools
Remember the functions of money with 'MUS': Medium of exchange, Unit of account, Store of value.
Acronyms
Think of 'M1' for the most liquid money and 'M3' for broader money measures.
Flash Cards
Glossary
- Barter Exchange
A system of trade where goods and services are exchanged directly for other goods and services without using money.
- Medium of Exchange
A function of money that facilitates trade by eliminating the need for barter.
- Unit of Account
A function of money that provides a standard measure of value for goods and services.
- Store of Value
A function of money that allows it to be saved and retrieved in the future without losing value.
- Narrow Money
A definition of money supply including currency and demand deposits.
- Broad Money
A definition of money supply that includes narrow money plus time deposits.
- Cash Reserve Ratio (CRR)
The percentage of deposits that commercial banks must keep as reserves with the central bank.
- Open Market Operations
Buying and selling government securities by the central bank to influence the money supply.
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