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Introduction to MONEY AND INterest

Rajneesh Mishra
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Definition of Money
Definition of money is a controversial issue Money can be defined as anything that is generally accepted as a medium of exchange and a measure of value.

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Sources of money supply

Central bank Commercial bank Non- banking financial intermediaries

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RBI MEASURE OF MONEY SUPPLY

M1 = C + DD + OD M2 = M1 + Saving deposits with post office M3 = M1 + Net time deposits with comm. Banks M4 = M3 + Total deposits with post offices

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Types of Money
Metallic coins Fiat money Electronic money Bank deposits

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Functions of money
Medium of exchange Store of value Measure of Value Standard of deferred payments

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Quantity theory of money

What determines equilibrium in money market? What determines the demand for money? How rate of interest is been determined in this market?
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Classical quantity theory of money

First of all conceived by French philosopher Jean Boldin in 1568. John locke David hume Richard cantillon David Ricardo Irving Fisher
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Fishers quantity theory of money

Most famous version of quantity theory of money has been given by Irving Fisher in his book Purchasing Power of money in 1911. All the versions of quantity theory emphasize the relationship between money and price level.
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MV = PT
M = Quantity of money in circulation. V = velocity of money. P = Weighted average of all individual prices. T = sum of all the transactions of goods and services per unit of time
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P = MV/T V and T remains constant, so P changes proportionately to the change in M. When M is doubled, P is doubled too According to Fisher, This mechanism makes clear the fact that the average price increase with the increase of money or bank deposits and with the velocities of their circulation, and decrease with the increase in the volume of trade.
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Criticism of quantity theory

Useless truism Velocity of money is not stable Increase in quantity of supply may not always lead to increase in aggregate demand Invalid assumption of constant volume of transactions
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Keynesian theory of demand for money

Motives for demand for money transaction demand for money Precautionary demand for money Speculative demand for money

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Transaction demand for money is directly related to level of income. People know by their experience the amount of money they require for transaction motive. Keynesian Transaction demand is interest inelastic.
Quantity of money demanded Mt = kY

Real National Income

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Precautionary demand for money

People hold money for unforeseen contingencies and unpredictable events like theft fire sickness etc. Precautionary demand for money is also a function of income. Mp = f (Y)
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Speculative demand for money

The desire to hold cash to take advantage of changes in the money market. Bonds are investments with long period of maturity V = R/i where R = interest payment on bonds which is fixed V = market price of bond i = nominal interest rate
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Relation between bond prices and interest rates

Assume D Market price Interest = 100 of bond P b 500 1000 2000 rate .20 .10 .05

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With the increase in rate of interest, the market value of the bond decreases and vise-versa. This means that speculative demand for money and interest rate are inversely related. Msp = f (i)
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Liquidity Trap

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There is inverse relationship between rate of interest and speculative demand for money.

Interest rate(i)

i3

i2 Liquidity trap i1 O Speculative demand for money(Msp)

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Msp

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There are two types of speculators: Bulls and Bears. Bulls are those who expect interest rate to go down and bond prices to go up. Bears are those who expect interest rate to go up and bond prices to go down. At interest rate lower than normal, even the bulls turn bears and they start accumulating cash balance.
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Keynesian demand for money function

Mt Msp Md= kY+f(i)

Interest rate Money

Money

Money

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IS-LM model

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ISLM model studies general equilibrium of the economy. Interdependence of product and money market. Equilibrium of product market- AD = AS Equilibrium of money market- Md = Ms Investment of product market and interest rate of money market are interrelated.
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Hicks has developed IS-LM model in 1937 IS curve shows relationship between the rate of interest and national income. At every point of IS curve product market will be in equilibrium.
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IS curve
S S=S(Y) S

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S=I

{3}
i

Y S(Y) =I (i) i

{2}

I=I (i)

{4}

{1}

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Derivation of LM Curve
LM curve shows relationship between rate of interest and national income. At every point of LM curve money market is in equilibrium.

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LM Curve
M1 = k(Y)

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Ms= Ma

{3} Md = M s

{2} M2=h (i)

{4}

{1}

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General Equilibrium of economy

LM Rate of interest

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IS O Income
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