Name: Shiza Nasim ID: 14466 Section: K

MACROECONOMICS ASSIGNMENT # 03

Question No.1: What is fiat money? What is commodity money?

FIAT Money: Money that has no intrinsic value is called fiat money. It is decreed to
be the legal tender by the government.

Commodity Money: Money that has some intrinsic value is called commodity
money. For example, gold and silver. QUESTION 2 (a): How is the quantity of money measured? Money Supply measures the quantity of money in an economy. It records the amount of money available in an economy in a specific period of time. As money is the stock of assets used for transactions, the quantity of money is the quantity of those assets. No single asset is used for all transactions. People can use various assets, such as cash in their wallets or deposits in their checking accounts, to make transactions, although some assets are more convenient than others. Currency is the first most obvious asset when talking about the quantity of money. The sum of outstanding paper money and coin, most day to day transactions use currency as the medium of exchange. Demand Deposits are the second type of asset used in transactions. They are the funds people hold in their checking accounts. If most sellers accept personal checks, assets in a checking account are almost as convenient as currency. In both cases, the assets are in the form ready to facilitate a transaction. Demand deposits are therefore added to currency when measuring a quantity of money. Funds in saving accounts can easily transfer into checking accounts. These assets are almost as convenient for transactions. Mutual funds allow investors to write cheques against their accounts, although restrictions sometimes apply. As these assets can easily be used for transactions, they should certainly be included as an asset when measuring the quantity of money.

Question No. 2 (b): What are the components of M1 and M2?

M1 = Currency in Circulation + Demand Deposits + Other Checkable Deposits + Traveler's Checks M2 = M1 + Savings Deposits + Small Time Deposits (CDs < $100,000) + Money Market Deposits + Other Stuff

DESCRIPTION: (for year 2000-2001) Currency in Circulation: Currency in circulation, being the most liquid form of money supply, has direct bearing on the movement of prices in the economy. During the 1980s, average annual increase in currency in circulation was 15.5% , which came down to 12.1% during the 1990s. In the first ninth month of current fiscal year, currency in circulation increased by 8.5%(Rs 30.2 billion), as against 18.9%(Rs 54.3 billion) in the same period last year. As on 31st March 2001, currency in circulation constituted 26.3% of money supply , Compared to its share of 25.9% in the comparable period of last year. Demand deposit with Scheduled Banks: Scheduled banks demand deposits increased by an annual average of 13.5% in 1990s, compared to 13.7% in the 1980s. During the first ninth month of fiscal year, demand deposit actually declined by 7.5% as compared to an increase of 9.4% in the same period last year. The outstanding stock of demand deposits was Rs 347.4 billion as on end March 2001, representing 23.7% of the M2 stock. On the corresponding date of last year demand deposit constituted 28.9% of M2. Part of the decline in the demand deposits can be attributed to the encouraging build-up in the time deposits and resident foreign currency deposits during the current fiscal year up to march 2001. Time Deposits: Time deposits of scheduled banks increased by an annual average rate of 18.6% during the 1990s, as compared to growth at 10.9% in the 1980s. Time deposits recording a contraction of 0.4% in the first ninth month of 1990-2000 posted considerable recovery during the first ninth months of the current fiscal year as they

grew by 7.1%. Their share in money supply M2 increase to 40.1% as on march 31, 2001, increasing from 39 on the corresponding date last year. Residents Foreign Currency Deposits: As a result of freezing RFCDs in May 1998, a large scale conversation into local currency has occurred, which continued in 1999-2000. However, during the 1st ninth months of the current fiscal year, RFCDs displayed considerable recovery. DESCRIPTION: (for year 2011-2012) Currency in Circulation: During July-May 2012 Currency in circulation, in flow terms, stood at Rs.204.3 billion as compared to Rs.255.5 billion in the broad money M2 grew by 9.09% During July-May 2012, as compared to an increase of 11.47% during the same period last year. The decline in broad money M2 came from the decline in broad money M2 came from the decline in both currency in circulation and deposit money. Deposits: During July-May 2012, demand ant time deposits stood at Rs. 402.5 billion as against Rs 403.5 billion during the same period last year. Hence the decline in currency in circulation is same period last year. Similarly, the currency in circulation as percent of money supply M2 has declined to 23.4% in 2011-12 as against 24.1 % during the same period in 2010-11. Offset by inc in demand and time deposits. Similarly, resident foreign currency deposits have inc to Rs 42.0 billion as compared to Rs 22.6 billion during the same period last year.

QUESTION 3: Write the quantity equation and explain it? TRANSACTION AND THE QUANTITY EQUATION: The link between transactions and money is expressed in the following equation which is called QUANTITY EQUATION. Money x Velocity= Price x Transaction

MxV

PxT

The right-hand side of the quantity equation tells us about transactions where: T = Total number of transactions during some period of time P = Price of typical transactions_ the number of dollar exchanged. PT = The number of dollars exchanged in a year. The left-hand side of the quantity equation tells us about the money used to make the transactions where: M = Quantity of money. V = Transactions velocity of money (which measures the rate at which money circulates in the economy) This type of equation is useful because its shows that if one of the variables changes, one or more of the others must also change to maintain the equality. Question No. 4: List all the costs of inflation you could think of and rank them according to how important you think they are?

International competitiveness: A relatively higher inflation rate will make British goods less competitive, leading to a fall in exports. However this may be offset by a decline in the exchange rate. But, if a country is in the Euro (e.g. Greece, Ireland and Spain) they can't devalue. Therefore, high inflation can be very damaging as it leads to a decline in competitiveness.

Confusion and Uncertainty: When inflation is high people are uncertain what to spend their money on. Also, when inflation is high firms may be less willing to invest because they are uncertain about future profits and costs. This uncertainty and confusion can lead to lower rates of economic growth over the long term.

Menu Costs. This is the cost of changing price lists. When inflation is high, prices need changing frequently which incurs a cost. However, modern technology has helped to reduce this cost.

Shoe leather costs. To save on losing interest in a bank people will hold less cash and make more trips to the bank.

Income redistribution. Inflation will typically make borrowers better off and lenders worse off. Inflation reduces the value of savings, especially if the saving is not index linked. However it does depends on the real rate of interest. e.g. if a saver gets a higher rate of interest than the inflation rate he will not lose out.

Boom and Bust Economic Cycles. High inflationary growth is unsustainable and is usually followed by a recession. By keeping inflation low it enables a long period of economic growth. E.g. in the UK, low inflation helped economic growth to be more stable in the period 1992-2007. Sustainable, low inflationary, economic growth is highly desirable.

Cost of Reducing Inflation: High inflation is deemed unacceptable therefore governments feel it is best to reduce it. This will involve higher interest rates to reduce spending and investment. This reduction in Aggregate Demand will lead to a decline in economic growth and unemployment.

Fiscal Drag. The amount of tax we pay will increase if there is inflation. This is because with rising wages more people will slip into the top income tax brackets.