MONEY: FUNCTIONS AND VALUE
In this chapter, we examine the evolution and functions of money, the qualities of good money, the systems of note issue, kinds of money, Gresham's law, the value of money, changes in the supply of money, relation between the supply of money and price level, and the changing value of money including the quantity theory, Index numbers, inflation and deflation. After going through this chapter, you will understand the functions and the value of money.
Humans have always been in search of things that will make life easier, pleasant and worth living. The primitives produced a few things but wanted numerous other things to satisfy their desires. How would they consume what they did not directly produce? Farmers used to produce food grains, fruits and vegetables. But they also needed shoes, furniture and gold ornaments. How could they procure these? The easiest option was to rob those goods. But they gradually realized that such an unsocial method of getting things was undesirable—it could only lead to chaos and confusion.
Having found that force was not a good way to get the goods they did not produce, they thought of “exchange”. If a farmer has surplus of food grains and a shoemaker can produce so many pairs of shoes, the best way would be to change certain quantities of food grains for a pair of shoes. A carpenter, in need of salt, would seek another person who required a chair and exchanged the surplus salt for the chair. This act of direct exchange of one commodity for another is known as barter. Barter economy was a name given to such exchanges at the level of the whole community. The difficulties of barter economy can be illustrated by citing the interesting example of a French singer who gave performances in an island where barter economy prevailed. She was paid in the form of pigs, goats, apples, bananas, etc. The pigs and goats ate up the fruits and other eatables and she had to give many more performances in order to earn food to keep her pigs and goats alive! Her fate was really pitiable. Had she been paid money for her performances, she would have become rich. The barter system stood in the way of her becoming rich. Let us trace the evolution of money from barter to its present form.
Barter was the first stage in the evolution of money. We have already seen the disadvantages of barter that prompted man to invent something better. Nowadays, we use metal coins and paper notes as money. But man did not invent coins and notes right from the beginning of human civilization. There was a gradual evolution from barter of commodities to money and from paper money to plastic money.
The next stage in the evolution of money was the adoption of certain animals or a commodity as a unit of account or standard measure of value. For instance, when a goat of a given size and weight was adopted as money, everything else was then measured in terms of this standard goat. If then, one goat was worth two chairs and one chair was worth 10 kg of wheat, the exchange ratio between a goat and wheat was easily determined: one goat was equivalent to 20 kg of wheat. In this manner, the value of everything was determined in terms of other goods—through the common measure of value, that is, the goat in this example. The exchange ratios between different goods were no longer uncertain and arbitrary. These were fixed in terms of one standard commodity—the goat. The community was on the goat-standard. This was, in a sense, the birth of modern money. People could now do away with the inconvenient system of barter. This was undoubtedly a remarkable invention in the history of human civilization. Gradually, the unit of account became the medium of exchange. Now wheat was not to be directly exchanged for a chair; wheat was sold for goat and goat was given in exchange for a chair. Goat became an intermediary; it was used for all purchases. It was generally acceptable because everybody knew that it was money and it could purchase each and everything as and when required.
Now the need to fix the exchange ratio among, for instance, several commodities was no longer necessary. For instance, under barter, if there were 100 goods, we required 4,950 separate exchange ratios. Under the “goat” economy, the worth of the remaining nine goods will be expressed in terms of goats. So, the number of exchange ratios was reduced substantially from 4,950 to 99. This was a remarkable achievement. When we are using hundreds and thousands of commodities as at present, our predicament in the absence of common denominator-unit of account would better be imagined!
The invention of the common denominator, namely money, made storing a simple matter by serving as a store of value. In a barter economy, people had to make arrangements to store a variety of goods—food grains, animals, etc. Managing all these created many difficulties. With the invention of money, nothing need be stored except money, which may take the form of any commodity.
To summarize, whatever performs three basic functions-units of account, medium of exchange and store of value—is money. As Geoffrey Crowther says, “money is one of the most fundamental of all man's inventions”.1 Every branch of knowledge has its fundamental discovery. In mechanics it is the wheel, in science, fire; and in politics, the vote. Similarly, in economics, in the whole commercial side of man's social existence, money is the invention on which everything else is based. Early primitive money took the form of animals. Primitive societies were agricultural and normally domestic animals occupied the place of pride as money. The cow, sheep, and goat were used for quite a long time. Not few references exist in Persian and Roman literature to the animal-money. But animals have serious disadvantages as a form of money. First of all, it lacks standardization. No two animals are the same in every respect. Someone borrows five goats of five varieties from someone else, but when returning these, the former gives the oldest and skinniest of goat to the latter. Such transactions will definitely create conflict between the two transactors. Besides, an animal could not be divided when a small payment had to be made. Moreover, it will create a problem of storing. How to keep hundreds of cows and goats? What about the upkeep of the animals? If an epidemic breaks out, most of the animals will die and the possessor of them has to suffer a terrible loss. Animals are not portable. To carry them from one place to another is really troublesome.
While a few communities were using animals as money, some other communities accepted certain commodities as the medium of exchange. The selection of commodities depended upon location, the climatic conditions and cultural development of the community. Countries with a cold climate were using skins and furs while people residing in the tropical regions chose elephant skins and tiger jaws. People settled in the neighbourhood of the seashore were using tortoise shell or fish-hooks as money. A wide range of things was adopted as money; besides the above-mentioned commodities, rice, tea, tobacco, wine, beer, knives, playing cards, etc. were used as exchange media.
As the years rolled by, both animal money and commodity money were given up and communities adopted gold and silver as money. Both these metals are attractive and are universally desired. The Rigveda and ancient Greek history make reference to these precious metals as modes of payments. As Toynbee, the well-known historian, says, the first known coins were struck in the Greek city-states about 700 BC However, the difficulty with these metals was that they were too scarce. Their supply was extremely limited. Meanwhile, other metals were also used as media of exchange, e.g. iron, bronze, copper, brass, nickel, lead, etc. These metals were abundant and so they were very cheap. In the mid-nineteenth century, gold-mines were discovered in California and Australia and thus the modern gold era commenced. Why was coinage resorted to instead of pieces of metals as money? The answer is simple. The use of metals gave rise to two difficulties: how to weigh the piece of metal every time payment was to be made and how to verify the quality of the metal. Coins were minted because they were convenient as a mode of payment. They were portable and were divisible into small units. The rulers used to put their seal on them and so nobody questioned the quantity and quality of the coins. Coins were round and flat; round because they were to be circulated and flat because they were to be stored.
As trade and commerce progressed, even gold and silver coins were considered inconvenient. Merchants found them dangerous to carry from place to place. They used to keep gold and silver coins with the goldsmiths who used to give them receipts. These receipts were accepted as a form of money. The goldsmiths were well known for their integrity and nobody questioned the validity of these receipts. Gradually, those receipts acted as the substitutes for metallic money. This marked the beginning of paper money.
Goldsmiths started issuing receipts of different denominations. These receipts were merely the titles to metallic money. They bore the legend: “On demand I promise to pay the bearer the sum of…”. These were the currency notes. They were more convenient to carry from place to place and easier to store. Slowly, the government or the central bank took over the function of issuing currency notes. The issuing authority continues the production of currency notes. For instance, the Governor of the Reserve Bank of India gives the “promise to pay the bearer the sum of” various amounts and you may see this promise on all currency notes in India except on the one-rupee note.
At first, paper money was simply a substitute for metallic money. Gradually, its convenience in various transactions, its easy portability and the ease with which it can be stored made the governments use paper notes along with the metal coins. The system of monopoly of note-issue by one bank, viz., central bank of the country, came into vogue. As present, a very large part of legally accepted money consists mainly of currency notes or paper money issued by the central bank or the government.
Credit money emerged along-side paper money. Credit money, also known as bank money, refers to bank deposits which depositors can withdraw or transfer to someone else through an instrument known as the cheque. The cheque itself is not money but it enables claims of money on a bank (i.e., bank deposits) to be transferred from one person to another. The bank cheque is the credit instrument and the actual money is the bank deposit kept by people with the bank. It is an important constituent of the money supply in an advanced economy. For instance, of the total supply of money in Britain, three- quarters of it is in the form of bank money while in USA, about ninety per cent of the transactions take place through cheques. Most of the large transactions nowadays are financed through cheques and only small transactions are managed through currency. Yet, the cheque is not money, but “near money” as it does not possess “general acceptability”. In advanced countries, however, the cheque is considered similar to money proper. To sum up, we can say that in the evolution of money, commodity money replaced barter in the first instance but it gave way to metallic money which in turn was replaced by paper currency. Nowadays, bank money is used increasingly for larger transactions, while paper money is used for smaller transactions.
Did barter economy disappear completely? No, although barter is a matter of the past it is by no means obsolete. Even today, in many less-developed economies, goods are exchanged for goods. In India, the village economy still adopts barter to a considerable extent. For instance, a villager goes to the weekly bazar and purchases groundnut oil by offering wheat. An agricultural labourer gets payment from the landlord in terms of food grains or partly in cash and partly in kind. The National Income Committee of India has estimated that out of the total transactions in India in 1954, about one-third were in terms of barter. (Often, an American purchases a new car by offering his old car and the balance amount in cash.)
At present, barter is used extensively in the sphere of international trade. The bilateral trade agreements entered upon by two countries are mostly on the barter system of transaction. For instance, India exports marine products to USA and gets machinery in exchange; sometimes, there are attempts on the part of several countries to revive the commodity money. Germany used cigarettes and cognac as a means of payment in 1945–46.
We all know that money performs a variety of functions in our society. Having lived in a money-based society and getting acclimatized to it, it is impossible to imagine life without money. When the Soviet Government after the Bolshevik Revolution wanted to do away with money, it encountered such serious problems that it had to quickly revert to a monetary economy. We are going to study all about money in this chapter, starting with its functions. The chart in Fig. 40.1 illustrates vividly the functions of money.
We have traced the evolution of money at length. But still the question remains unanswered: What is money? It is really an unnecessary question because money belongs to the category of goods which cannot be defined in precise terms. Walker defines it as: “Money is what money does”.2 Other economists such as Seligman and Robertson emphasize the general acceptability aspect of money. The significance of money will become clear if we analyse the functions of money in detail. In modern times, money performs a number of functions. The following are the most significant functions of money:
- Medium of exchange: This is the most important function of money. The barter system was very inconvenient for buying and selling because it necessitates the double coincidence of wants. This is easily overcome by using money as a medium of exchange. A farmer need not go to a shoemaker and find out whether the latter is willing to exchange a pair of shoes for one bag of wheat. He goes straight to the market, sells wheat for money and with the money purchases a pair of shoes. A shoemaker is happy to accept money because it enables him to purchase anything he requires. A singer gets money for his/her performances and with the help of money buys food, clothes and all other things. The introduction of money splits transactions into buying and selling and facilitates exchange. The difficulty of indivisibility of certain articles is also eliminated. Money units are of all denominations and it is easy to make fractional purchases which are not possible under barter.
- Measure of value: As we measure clothes in metres, distance in kilometres and milk in litres, we measure the value of all goods and services by the measuring rod of money. Money serves as a common denominator and every transaction is referred to a common unit. If a piece of chalk costs 10 paise and a duster costs 1 rupee, we may conclude that the value of a duster is equivalent to that of 10 pieces of chalk. The need to fix the exchange ratios between innumerable commodities is removed. In matters of exchange, a common standard of value makes the transaction easy and also fair.
- Store of value: Money serves as a store of value. It is very convenient to carry currency notes about or to keep them in the house. Some of us get our incomes once a month while we have to incur expenditure through the month. Hence, there is the necessity to store money. Under the barter system, storing created immense problems. The accumulation of wealth in the form of goods is certainly risky. To store cattle and grains in large quantities is certainly difficult. Cattle could be killed by disease and epidemics, while food grains could be stolen or destroyed by pests or fire. We would like to store and accumulate wealth for ourselves and our future generations. Storing of wealth in the form of paper money or bank money is extremely simple and convenient.
- Standard of deferred payments: “Deferred payment” means postponed payment. Lending and borrowing are inevitable in our everyday life. We borrow today and repay later. If borrowing and lending are in terms of a commodity, its value will not remain stable over a long period of time. Most commodities deteriorate with the passage of time. By serving as a standard measure of deferred payments, money makes borrowing and lending less risky. The value of money remains more stable than that of other commodities. It is true that the value of money also changes, but normally, its value does not change to the extent the value of other articles changes.
Figure 40.1 The Functions of Money
All these functions are not independent of each other. In fact, the basic function of money is its being a medium of exchange. Other functions are derived from it. It is because money is used to exchange commodities that each commodity gets a value in terms of money. Value expressed in terms of money is called price. Thus, the measure of value is derived from medium of exchange. Because money is useful as medium of exchange, people store it. Finally, payment is made through money either immediately or later on when there is a transaction. Hence, of the functions of money, its being a medium of exchange is the basic one.
Money performs some other dynamic functions also. They are called contingent functions. For money to be the medium of exchange and measure of value is the primary function of money. For money to be a standard of deferred payments and a store of value is its secondary function.
- Money has liquidity: Another aspect made much of by modern economists is the liquidity of money. A person with money can get any commodity anywhere and money never lacks a buyer. People may refuse to accept other commodities but will not refuse money or refuse to sell goods against money. Hence money is the most liquid of all resources.
- Transfer of value: Money helps us to transfer payments from one person to another and from one place to another. Money is readily accepted by all and in all places and there is no difficulty in transferring even a large sum of money from a person in one place to another person in some very distant place.
- Basis of the credit system: The modern economy is based on credit i.e., promises to pay. The entire economy is dependent on such promises to pay one another.
- Distribution of national income: Money helps in the division of national income between people. In a modern society, people join together as workers, owners of capital, landlords, etc. and produce goods and services. This output is jointly produced and will have to be distributed among all of them. Money helps to distribute these goods and services through the system of money in the form of wages, interests, rents and profits.
- Basis of transaction: Money as the medium of exchange and measure of value facilitates transactions. But for the introduction of money, the modern world would not have progressed so much in terms of trade and commerce. With the help of money, businessmen are able to span time and distance and buy and sell goods irrespective of the constraints these factors create. Therefore, money plays a crucial role in the modern world of trade and business as the means of transactions.
- The basis of price mechanism: Price is a very important link in the process of exchange. It is money that helps people to evaluate the quality or quantity of a product in terms of the price at which it is offered. Price is the value of the commodity expressed in terms of money. Price is often the indicator of the value of a commodity, though there may be other factors that play a role in price fixation. Price is fixed as a result of demand and supply of goods in the market place.
Money occupies a central place in modern economy. Without currency notes and bank money, it is impossible to imagine a modern economy based on complex division of labour and extensive trade and commerce. The largest numbers of people in society are concerned with the earning and the spending of money. Money has become the centre around which economic science clusters. The erstwhile USSR under the communist regime wanted to establish the “moneyless economy” in 1917. But such an economy failed to function and Lenin admitted in October 1922 his mistake of abolishing money. Money is one of the greatest inventions of man similar to the wheel, fire, ink and the atom.
Qualities of Good Money
To perform the different functions satisfactorily, money must possess certain qualities. The following are the qualities of good money:
- General acceptability: The main characteristics that distinguish money from other economic goods is that it is universally accepted in discharge of debts. Whatever performs that function is by definition, Money. In other words, the thing that is used as money must be such that all the people are ready to accept it, use it to meet their different, economic transactions without reference to the person, place or time.
Money may derive its general acceptability from three ways: (a) intrinsic value, the metal used as money is valuable for its own sake, and it can be used for other purpose, for example, gold and shiver; (b) government decree, the government of the country declares it as legal tender, so that no resident of that country can refuse to accept it and (c) common consent, that is, the receiver has faith that it will be accepted by people to whom he offers it subsequently.
- Stability in value: The changes in value of money affect the ability of an economy to function effectively in its different capacities. People use money to store their wealth, to meet deferred payments. Moreover, money is used to account and express the values of other goods and services. If the value of money falls, people avoid holding it, they prefer to hold real assets instead. The constant fluctuations in its value will impair the standard of deferred payment function as it will not be acceptable either to borrower or to tenderer, with a fall in value of money creditors will get depreciated currency; naturally he will not be ready to lend the money. The money will also work less efficiently as a unit of account; it will give different values at different times.
The stability may be derived from by using a scarce material such as gold or silver as money, by regulating and adjusting its supply in accordance with prevailing economic conditions and requirements of the economy.
- Durability: A thing which is used as money must not be such as to deteriorate in its quality. One must be in a position to preserve and use it for a long time, for a unit of money may be used continuously in exchange for goods and services. Moreover, money is used to store the value and to meet the deferred payments.
- Divisibility: Money is to be used even to make the smallest transactions, it is to serve the purpose of unit of account, as such a thing used as money must be such that it can be spilt-up into small denominations and in this division there must be no loss of value.
- Homogeneity: The notes and coins used as money must be identical and uniform in all the respects, viz., size, colour, weight. One must not feel that, say, a note of rupee is different from other note of rupee. When a person feels like that, he will not accept it. In other words, money will then not be universally accepted.
- Portability: One must be in a position to carry a large value in small bulk over a long distance for settlement of claims without experiencing any type of difficulty.
- Cognizability: A thing which is to function as money must be such that anybody, even the ignorant, illiterate, blind must be in a position to recognize it, distinguish it and know it's worth so that there will not be any confusion and the possibility of counterfeiting. It means a coin of a particular denomination must be uniform, standardized and at the same time it must be different from the coin of other denominations.
SYSTEMS OF NOTE ISSUE
The amount of paper money, i.e., currency notes in circulation at a time is generally a fiduciary issue system. There are three systems of note issue:
- Fixed Fiduciary: Under this system, a given quantity of notes is issued without any metallic reserve but on the backing of government securities.
- Proportional Reserve System: This implies that a proportional metallic reserve is kept against the quantity of notes issued.
- Fixed Minimum Reserve System: In this case, certain minimum amount of gold and securities is kept irrespective of actual notes issued. In India we follow this system. The minimum reserve maintained is INR 1.15 billion in gold and INR 4 billion in foreign securities. Paper money may be convertible or inconvertible. When government accepts to pay on demand standard money in exchange, it is convertible.
KINDS OF MONEY
Money usually is classified as common money and bank money. Common money or money of account refers to “Money proper”, the currency notes and coins used in economic transactions. These currency notes and coins are issued by the monetary authority or by the government of the country. Common money must be accepted by all the residents of that country. In our country, common money consists of coins from one paisa to one rupee and all the currency notes of different denominations. The Indian notes and coins are essentially “Fiat” money. These are money because they are accepted by common consent, people have faith in them and they are backed by the Government of India and Reserve Bank of India. Bank money, also called optional money, refers to the monetary instruments issued by commercial banks which also carry out the normal functions of money. These are cheques, bills of exchange or hundis and drafts.
If a currency has to be accepted by people and has to circulate in a society in exchange of goods and services and other obligations, it has to have legal sanction. When such legal sanction is conferred to a money, it is called legal tender. The government of a country accords legal sanction of various kinds. For instance, we have limited legal tender and unlimited legal tender. We will study various types of legal tenders in the following pages:
- Common money is further classified as limited legal tender and unlimited legal tender. Legal tender money circulates and is used in all transactions for it has the sanction of law. It is lawful money.
- Limited legal tender money implies that certain types of notes and coins can be used in settlement of economic transaction only up to a specified amount. A receiver can refuse to accept it beyond that limit. In our country all the coins except one rupee coin are limited legal tender.
- Unlimited legal tender can be used to make the payment of any amount one cannot refuse to accept it. In India, one rupee coin and all the currency notes are unlimited legal tender.
Figure 40.2 clearly illustrates the various kinds of money that are in circulation today.
Standard Money and Token Money
Money can also be classified as standard money and token money.
- Standard money: It refers to the monetary unit in terms of which other different units and values are accounted and expressed. Rupee is standard money. In case of metallic money when intrinsic value of money is equal to the face value, it is considered as full bodied money. Standard money is always unlimited legal tender. Though, the rupee in India is a standard money, it is not subject to free coinage and its face value is higher than its intrinsic value. All the other coins are token money.
- Token money: When the intrinsic value of money is less than the face value of money, it is considered as token money. These coins are valued more than their metallic worth for they can be easily converted in to standard money, e.g. 25 paise or 50 paise coins into rupee notes. Token money is limited legal tender and free coinage of them is not allowed.
- Bank money: It refers to bank deposits, withdrawable by cheques or drafts. In modern economy, most of the large transactions are financed through cheques. The bank money is considered as “near money” as it does not possess general acceptability.
Gresham's Law explains that when good money and bad money circulate simultaneously and when they are full legal tender, bad money drives good money out of circulation. The law expresses a simple human tendency. A man always tries to dispose off things which are bad and less valuable and keep good and more valuable things. For instance, suppose you are travelling in a bus and you have two 10-rupee notes, one of which is worn out, dirty and the other brand new; while buying a ticket you give the bad note and keep the brand new note. Then old notes, debased coins are considered as bad money, money of inferior quality and, therefore, people try to spend them first. Bad money does not, however, mean illegal or counterfeit money.
Figure 40.2 Various Kinds of Money in Circulation Today
The law operates both with respect to metallic and paper money. Under the monometallic system, people will hoard the good money; they may melt it and turn it into ornament or use for other purposes; they may export it. This is because good money has more weight. Under bimetallic standard they may convert it from gold to silver or from metal to coins, to take the advantage of changes in price of silver or gold as metals, that is, due to change in market ratio one becomes more valuable than the other. In case of paper money, since new notes are more durable than old, people will first spend the old notes.
Thus, only the bad money will remain in circulation when both good and bad money circulate together.
However, there are certain limitations on the operation of the law:
- When total supply of money is less than the demand, people have no alternative but to use good money.
- The law fails to operate when bad money is so bad that nobody is ready to accept it. In other words, when public opinion is against the use of bad money, there will be no acceptance of it.
- Many a time, people are not in a position to distinguish between good and bad money. They sometimes may not be aware of the fact that both good and bad money are in circulation.
THE VALUE OF MONEY
Understanding the value of money is as important as understanding the role of money in an economy. Only by understanding the value of money and what constitutes its value, we will be able to make use of money in an efficient and sensible manner. In the following pages, we will try to understand what is meant by the value of money and the factors that determinate it.
In ordinary speech we often speak of the value of a thing when we mean its price. Price is the value of a good expressed in terms of money. It indicates the terms on which it can be exchanged for money. But when an occasion demands it, how to reckon the value of money itself? When we talk of the value of money we refer to the goods and services a unit of money buys. If at one time a certain amount of money buys fewer things than at a previous time, it can be said that the value of money has fallen. Since money is used as a unit of account and as a means of measuring the value of other things, its own value can be seen only through the price of other things. Since this is so, to find out the value of money we have to reverse the normal way of estimating the value of things. Money, being the common denominator by which the total “value” of a heterogeneous mass of goods can be calculated by adding up their prices, its own value cannot be stated in so simple a fashion. Money, unlike other goods, is not wanted for its own sake; it is wanted because it buys other goods. In the case of money, there is no common denominator which can be used for indicating its value. For every commodity or service or purpose for which money is required, it really has a separate and distinct value. The value of money in terms of bicycles may be vastly different from the value of money in terms of butter.
Case 40.1 Gresham's Law in Action!
As per Gresham's law, people hoard “good” money but spend “bad” money. Inflation in India has made the rupee almost valueless, but the little metal in the coins is so valuable that millions of Indian coins are being smuggled into neighbouring Bangladesh and turned into razor blades! How much valuable is the metal in the coin? The conversion ratio is a one-rupee coin can be made into seven razor blades, worth 35 rupees!
The natural result of Gresham's law in action was an acute shortage of coins in many parts of India. This phenomenon of coins disappearing happens elsewhere, too, as all currencies are being debased by their central banks, and coins with a low, fixed denomination on them are doomed as the buying power of the coin falls below the melt value of the metal in the coin. For instance, Singapore stopped issuing one cent coins from 27 February, 2002 because the public did not actively use it, just as in India, people have given up using the 5, 10 and 25 paise coins even though they are still limited legal tender.
Source: “Gresham's Law and the Indian Coin Shortage”, http://www.post1.net/lowem/entry/gresham_s_law_and_the.
A further ambiguity has to be cleared before we proceed further.
The words price and value are often interchangeably used, which is not correct. An article priced at INR 10 does not possess twice the value of one marked at INR 5. The price of a commodity, rather than measuring its value, only indicates it. While the price of a good indicates its money value, the price of money does not indicate its value in terms of other goods but the payment that has to be made for the use of a sum of money for a specified period; that is, the interest payable on a loan. The price of money, therefore, is the rate of interest. All these difficulties arise because “the value of money” is a highly subjective concept, it has different values in terms of different commodities and services, the rate of interest being the value of money for a particular purpose—borrowing and lending.
The value of money, like that of any other commodity, will be influenced by both the demand for it and its supply. If, for instance, we imagine a situation where all prices were halved, then we could manage with half the amount of money we previously spent on our living and be as comfortable as we were. In such a highly imaginary situation, value of food, clothes, drinks, etc. would have all remained unchanged including the ratios of exchange between them, while the general value of money would have doubled. But such a situation will never arise because money is a dynamic force. The value of money changes often, which changes the prices of other things. Changes in the value of money occur whenever there are changes in its demand or supply or both. We will now turn to the analysis of demand for and supply of money.
The Demand for Money
The concept of “demand for money” presents very many difficulties because it is liable to be interpreted in different ways. Sometimes, the demand for money as a medium of exchange is confused with the demand for incomes. The demand for money is a derived demand in the sense that it is not demanded for its own sake but because it represents goods and services. The demand for money arises out of the total volume of transactions that are effected with it. It is the sum of (i) the final selling value of the current output of goods and services which are actually sold during a particular period, (ii) the total of the successive selling rates of the ingredients of which final output is made, including selling values at intermediate stages of production and (iii) the selling value of such pre-existing durable or second-hand goods that are actually exchanged during the accounting period. The demand for money, thus, is the demand for purchasing power. There is another way of looking at the demand for money. It can be interpreted as the demand to hold money as an alternative to saving or investing it. If a person prefers to hold money in liquid form, he gives up the desire to invest it. In other words, the demand for money reveals the liquidity preference on the part of income receivers and wealth-holders.
The demand for money arises from the fact that money is both a medium of exchange as well as a store of value. The classical economists considered money only as a medium of exchange, i.e., as an instrument that effected transaction and neglected the function of money as a store of value. Later on, Keynes brought out to the fore the “store of value” functions of the demand for money. The demand for money is influenced by different motives to hold it in its liquid form. Money is not only used for day-to-day transactions, but also preserved in a form of wealth that is easily convertible into liquid cash or any other form of wealth without involving much time and resource in the process of such conversion. According to Keynes, the various liquidity motives are transactions, precautionary and speculative, on account of which it is demanded.
- Transactions motive: Individuals and corporations demand money because it is a medium of exchange. If they receive money as and when needed to buy goods and services, there is no need to hold money. But there is a time lag between the receipt of incomes and their expenditure. This necessitates holding of money in cash form to meet day-to-day transactions. The demand for money for transaction purposes depends upon income, the manner and frequency of the receipt of income, the banking habits of the people and the general level of economic activity.
- Precautionary motive: Individuals and corporations keep more money with them than the amount needed to meet the transactions motive, especially if they are cautious and do not want to take a chance with the vagaries of an uncertain future. Individuals may have to face certain unforeseen contingencies such as unemployment, accidents, sickness, a necessary travel, a sudden arrival of guests, etc. How much each individual will keep depends upon many factors. Some are not temperamentally inclined to save and spend their incomes as quickly as they received it, while some others may have nightmares of their future and keep a lot of money in liquid form. How much cash a person will hold on account of such unforeseen events will depend upon his psychology, his views on the future and the extent to which he wants protection. Like individuals, business firms also hold cash to safeguard against future uncertainties. The quantity of cash balances each firm will hold depends upon its degree of confidence to face and survive an unexpected calamity, wave of optimism or pessimism, access to credit and finance, and the facilities for the quick conversion of illiquid assets into liquid cash. As long as individuals and business firms have an easy access to ready cash, the precautionary motive to hold money will be weak.
- Speculative motive: This motive for liquidity preference is the most significant in determining the total demand for money in an economy. The total amount of money held for transactions and precautionary purposes being custom-bound and tradition-oriented, it will not vary much in the short period unless the price rise is very steep, as in a period of inflation, when clearly more money is required to pay for a given quantity of goods and services. Therefore, if the total amount of money held by the community as a whole varies very much, it will be for the speculative motive. To hold money involves a loss of interest it would otherwise have earned, and so it costs money to hold money. If, however, the prevailing rate of interest is expected to rise in the near future, the loss of interest may be more than balanced by the gain from the purchase of a security or bond at a lower price. The main influence on holding money is expectation of the future trend of the rate of yield on securities. Thus, the speculative demand for money arises on account of the uncertainty regarding the future rate of interest. Obviously, the demand for money is highly sensitive to changes in the rate of interest. It is the uncertainty regarding future market rates of interest on bonds and securities of different maturities that enable people to speculate, especially in developed countries; and if their guesses regarding future rates turn out to be true, they stand to gain.
- Deflationary motive: Deflationary motive refers to a situation when consumers will tend to hold the money in liquid form rather than purchase goods for a month or so ahead of their requirement, when they observe falling prices; when prices fall, they will be able to buy more goods for the same amount of money as the real income increases in such a situation.
Supply of Money
The supply of money means the total amount of money in circulation in an economy. The effective money supply consists mainly of currency and demand deposits. All paper currency issued by the central bank and all coins issued by the government that are in currency will constitute the money supply. Bank deposits are regarded as money, as in advanced countries they are used through cheques in discharge of monetary obligations. Economists give money a much broader meaning and would include even near money such as savings, deposits and government bills. Before we deal with the currency and deposits in greater detail, we must distinguish between what is money and what is not.
- The first distinction we have to make is between the supply of money with the public and the stock of currency with the government; whereas the total amount of domestic means of payment owned by the people at large are included in the “money supply”, the cash balances held by the central and state governments, with the central bank and in treasuries, are generally excluded from it. This is because these balances arise out of the non-commercial and administrative operations of the government. Thus, the quantity of money means the total amount of money in circulation at a particular period of time.
- Another distinction we have to make is between the deposits held by current account holders and deposits held by fixed or savings account holders. While the former constitute the active money supply, the latter are at best regarded as near money or quasi-money. This is because the time deposits of commercial banks can be withdrawn only at the end of a fixed period. These are not the means of payment though these are the equivalents of the means of payment. These are no doubt liquid assets but they are not liquid enough to be ranked as money. What distinguishes time deposits from demand deposits is the fact that though these earn interest, these can be used as a means of payment only after some delay. As such, time and savings deposits are excluded from the “money supply”.
- Further, the active “money supply” would also exclude the stock of gold that serves as international money and is not permitted to circulate within the country. We have to also exclude the currency and demand deposits owned by the treasury, the central bank which hold these funds as reserves to support the demand deposits of their respective clients. These exclusions are necessary as otherwise there would be double counting in the quantum of money supply.
From the above exclusions we have made, it is clear that money supply will mean the quantity of currency (notes and coins) and the demand deposits with banks. Figure 40.3, represents the constituents of money supply, as explained by modern economists.
Figure 40.3 The Supply of Money
Changes in the Supply of Money
The changes in the value of money can be viewed from two angles: (i) a moment of time and (ii) a period of time. While the former relates to the monetary elasticity, or the capacity of money to adjust itself in an appropriate manner to implied changes in the needs for money, the latter refers to the velocity of money, or “the total amount of money in circulation multiplied by the average number of times it changes hands during a given period of time”.
Monetary elasticity is the ability of the supply of money to adjust itself to changes in the volume of trade without affecting the general price level. An increase in supply of money arises due to (i) the excess of government expenditure financed by taking loans from the central bank or by selling its securities to the banking system or by way of printing more money, and (ii) the increase in loans and advances from, and selling shares and securities to, banks by the private sector. A decrease in supply of money occurs under the opposite conditions. These are all instances of a simple change or variation in money supply. This type of elasticity of money occurs to meet the seasonal or cyclical monetary demand. Thus, elastic money supply refers to the situation occurring in a monetary system in which the volume of currency and deposits can be varied to meet different needs. The degree of monetary elasticity depends on the action and power of the central bank. If the money market is well organized and developed, the central bank can perform the function of monetary elasticity with efficiency. Thus, a change in monetary needs necessitates a change or variation in money supply and this in turn, necessitates elasticity in the supply of money.
As we have seen, velocity of money refers to the average number of times each unit of money changes hands or is spent on goods and services during a given period. For instance, a 100 rupee note that changes hand only once buys goods and services worth only INR 100 whereas when it changes hands five times it purchases goods and services worth INR 500 and consequently will affect the general level of prices to that extent, assuming other things to be constant. Thus, the price level is affected not only by the quantity of money (M), but also by its velocity (V). In algebraic terms, the supply of money during a given period is denoted by M*V. Velocity of money will depend upon the time involved in receiving and spending the money, methods and habits of payments, liquidity preference of the community, trade and business conditions, etc.
Relation Between Money Supply and Price Level
Prices are rarely stable over a period of time. Prices fluctuate due to disequilibrium between the demand for and supply of money. Inflation which is “too much money chasing too few goods’ is today a worldwide phenomenon. In India, prices have been steadily rising since 1950s and critics of the government blame it for releasing too much money while the goods remained too few. This is only partly true. It was the contention of traditional economists that changes in the price level were influenced by the changes in the quantity of money. They contended that an increase in the quantity of money brought about a more or less proportionate increase in the price level and likewise a decrease in it brought down the price level. This is what is known as the quantity theory of money. It is based on the assumption that, when firms and households have more money than they wish to hold, they will spend the excess on the available goods and services leading to a rise in their prices or inflation. Contrarily, when they have less money than they wish to hold, they will try to build up their cash balances by reducing their expenditures on goods and services to an amount less than their current incomes leading to fall in price or deflation. According to this hypothesis, disequilibrium between demand for and supply of money causes changes in aggregate demand for goods and services leading to changes in the price levels and consequently the value of money. But the Keynesian Theory of Money destroyed the basis of this hypothesis by asserting any direct link between the supply of money and the price level.
In most of the countries of the world, the money issued by the central bank constitutes the country's entire currency. But in certain countries, the treasury also issues notes or coins along with the central bank. In India, for instance, while the notes of two rupee and higher denominations are issued and managed by the Reserve Bank, the one rupee notes are issued and managed in circulation by the Ministry of Finance of the Government of India. The supply of paper money in a country is governed by the system laid down for the purpose. Broadly speaking, there are two important methods of note issue, namely, (i) the Fixed Fiduciary system existing in UK, and (ii) the Proportional Reserve System as practised in USA and India. How much currency people of a country will like to have will depend on their currency needs reflected through their economic activities. The treasury, the central bank and commercial banks are only agencies through which their preferences are expressed. The desire of the public to hold more or less currency, or more or less of particular denominations of currency, is normally influenced by such factors as the volume of trade, nature of trade, price level, banking habits of the people, methods of payments, volume of demand deposits, volume of transactions, distribution of national income, methods of taxation, public loans, deficit financing, the level of literacy, etc.
Almost three-fourths of the total supply of money in advanced countries, such as USA, are in the form of demand deposits of the people held in banks. In those countries, almost 80 per cent of the payments are made by the public through cheques. Demand deposits are easily convertible into cash without loss of time or money. Besides, payments through cheques provide certain advantages: One need not carry heavy load of currency to make purchases; cheques can be issued to any amount by a simple operation of penning a few lines; it is made safer once it is crossed; its counterfoil provides the customer a record for his accounting purposes and so on. Thus, in these countries, the course of behaviour of the internal price level is greatly affected by changes in the volume of “primary deposits”, that is, the original deposits of the people that represent their savings and “derivative deposits”, that is, the result of banks’ loans and advances to customers through the process of credit creation.
The relative amounts of the two main sources of money supply depend upon the degree of monetization of the economy, banking habits, banking development, trade practices, etc. in the economy. But in developing countries like India, the proportion of cash, that is, currency and coins, to the total money supply is considerably large because of the existence of non-monetized sector, of a large unorganized banking industry, illiteracy, absence of thriftiness and banking habits, inequality of incomes, etc.
THE CHANGING VALUE OF MONEY: THE QUANTITY THEORY
The value of money, like the value of any other commodity, changes from time to time. Why does the value of money rise or fall? The quantity theory of money provided an answer to the question. The quantity theory of money was accepted as a satisfactory explanation of changes in the value of money sometime ago, while some new theories are propounded to explain the phenomenon. The gist of the quantity theory is that the value of money depends primarily on its quantity. According to the quantity theory, price level varies directly with the quantity of money and inversely with the volume of trade. That is, if the quantity of money is doubled, price level also will be doubled and therefore, the value of money will be halved. The quantity of money remaining constant, if the volume of trade (goods and services) is doubled, price level will be halved and, therefore, the value of money will be doubled.
The Theory is best expressed in the form of an equation given by Irving Fisher.3
P is the price level
M is the coins and paper notes in circulation
M' is the volume of bank deposits
V is the velocity of circulation of coin and currency notes
V' is the velocity of circulation of bank deposits
T is the volume of trade in goods and services against money or the demand for money.
It should be obvious that this statement is a truism, that both sides of the equation must equal each other. MV + M'V represents the aggregate of the money-values exchanged against goods in a certain period of time—the quantity of money multiplied by the rate at which it is used must give us the aggregate on the money side of the total exchange transactions. PT is the number of transactions times the average price and thus is the total valuation of the goods exchanged against money in the same period of time. From this equation, we understand how the changes on one side bring about the changes on the other.
Thus, according to the quantity theory, at any given point of time, the supply of money (the total quantity of money) would be equal to M, i.e., coins and paper notes, plus M', i.e., the volume of bank deposits. But when we consider the supply of money over a period of time, the velocity of circulation of money will average the number of times each unit of money changes hands over a given period of time. Thus, the quantity of money over a period of time is represented by the sum of MV and M'V', which gives the price level when divided by T.
The quantity theory of money assumes the following:
- Other things being equal, the classical criteria of ceteris paribus is the basic assumption of this theory.
- That business conditions are normal at a period of time.
- P is a passive element in the equation which is determined by other terms in the equation.
- That the velocity of circulation (V and V') is constant. Velocity of circulation of money depends largely upon the psychology and the habits of people which, in the short run, are not likely to change.
- That the volume of transactions (T) is fixed and constant. The volume of production depends upon the quantity and quality of the factors of production which, in the short run, do not change.
The weakness of the Theory has been exposed by the severe criticisms which have been levelled against it:
- It has been said that the quantity theory is not a theory at all. It is a way of showing that the four variables, M, V, T and P are related to one another.
- It is said to be a truism because MV must always equal PT since they are merely different ways of looking at the same thing.
- It is pointed out that the four variables M, V, P and T are not independent of one another, a change in one inducing changes in the other.
- The assumptions of the quantity theory are unrealistic. V, V' and T are never constant. For example, during a period of inflation, when prices rise V, V' and T also increase due to brisk business conditions which necessitate an increase in the circulation of money.
- The quantity theory of money attributes wrongly all changes in the value of money to change in the quantity of money. A change in price level caused by a scarcity of goods and services can also bring about changes in the value of money.
- There is really no general price level, but a series of section price levels, as the cost of living index number reveals.
- It is claimed that the theory only attempts to explain changes in the value of money but not how the value of money is, in the first place, determined.
- The quantity theory looks upon changes in the price level as the effect of changes in money supply. But, according to Keynes and many other economists, both the supply of money and the price level are the effects of income which will increase the demand for goods and services. As a result, the price level will begin to rise bringing down the value of money. Therefore, the value of money depends more on the level of income rather than on the quantity.
- It has been said that it is totally inadequate as a theory of money since it does not take into account the rate of interest at all.
- Very often, an increase in the quantity of money may not affect the general price level at all. A part of it may be hoarded. A portion of it may be paid as premia for LIC, Provident Fund, etc. An increase in money supply may also be used to buy luxury articles. All these will not adversely affect the general price levels. Sometimes, additions to the money supply may be used to employ the hitherto unemployed resources and increase production in the economy. Additional production will neutralize excess money and prices will not rise.
- According to Fisher's formula, if the quantity of money is doubled, the price level will be doubled and if the quantity of money is halved, price level will also be halved. It may be pointed out that such accurate and proportional changes, as suggested by the formula, occur only under special conditions. In the real world, a doubling in money supply does not raise the price level exactly by 100 per cent. The rise in the price level may be more or less than 10 per cent.
- The assumptions on which the theory is built up are for short periods while the theory itself measures the changes in the long period.
- The theory explains the phenomenon of prices in a static equation. But the real world is a dynamic one where changes rather than stillness are the facts of life.
- The prescriptions of the theory have been misrepresented by history.
For example, during the early 1930s, many countries including USA which were affected by the Great Depression tried to bring about a revival by increasing the volume of money. But, it did not lead to any recovery.
Despite the criticisms noted above, the quantity theory of money is useful in so far as it points to the influence which the quantity of money exercises upon broad movements of prices over the course of history. It is now generally admitted that the quantity theory comes into its own in a period of severe inflation. At such times, a large increase in the quantity of money occurs when the great increase in the velocity of circulation cannot be offset by a corresponding expansion of production. As a result, prices rise steeply proving the central truth of the theory.
MEASURING CHANGES IN THE VALUE OF MONEY: INDEX NUMBERS
The value of money represents the purchasing power of a unit of money. The value of money means, therefore, the amount of goods and services a unit of money can command while buying them. If INR 10 could buy a ball pen, a chocolate, a soft drink, etc., then its value is to be reckoned in terms of these goods. Just as we measure the value of goods in terms of a unit of money, do we measure the value of money in terms of goods? The number of commodities and services available for exchange with money is very large. They are also priced differently. It is therefore, impossible to express the value of money in absolute terms. But we can express the value of money relatively, that is, we can measure the changes that have occurred in the value (i.e., purchasing power) of money from one period to another. This is done through the index numbers.
The values of commodities expressed in terms of money are called prices. The average price arrived at out of a series of prices of commodities is called the price level. The average of a series of price levels representing both a time period and a list of commodities and arranged in tabular form is called the index number. An index number, therefore, can be defined as a device used to show relative changes in prices or the value of money over a period of time. The purchasing power of money depends on the price level. If the price level rises, money has less value and buys less. Conversely, if the price level falls, money has more value and buys more in terms of goods and services. Thus, the value of money varies inversely with the price level.
Method of Construction
To construct an index number, we must be, first of all, aware of the object for which it is done—whether it is to be a working class index number to determine the level of wages or allowances of workers, or a general index number to measure changes in the purchasing power of money, etc. The next step is to select a list of commodities that would be fairly representative of the consumption of the class of people to whom it is intended. For instance, if it is a working class index number, we will select groundnut oil rather than ghee to represent oils in the list of consumer goods. Once the list of commodities is chosen, we proceed to obtain the retail prices at which they are sold in the current year. These prices are to be compared with the prices prevailing in the base year. The base year is one in which the prices are fairly stable. This should be a normal year when production, prices, etc. are stable compared to other years. In the base year, we take the price index as 100 for all commodities irrespective of the prices prevailing in the market, compare them with the prices of other years and work out the price changes in terms of percentages. The choice of the base year and assigning it the value 100 is to show subsequent percentage changes in prices.
The method of constructing index numbers is explained below.
Suppose that the price of rice per kg was INR 20, INR 30, INR 25 and INR 50 in years 2005, 2006, 2007 and 2008, respectively. Let us take year 2005 as our starting point or base and represent the price in that year, INR 20 by 100. Then the price in the year 2006 (INR 30) will be represented by the figure 150. The figure 150 is called the price relative of prices in year 2006. By a similar method, the price relative of prices for years 2007 and 2008 are found to be 125 and 250, respectively. These price relatives show at a glance in what proportion the price of the selected commodity has changed over a number of years. If we take a group of commodities, we can find out their price-relatives and list them in a table. It will be an index number as reproduced in Table 40.1.
The average of price relatives in the year 2005 is 100; and those in years 2006, 2007 and 2008 are 129, 156 and 258.5, respectively. These numbers are index numbers of prices. They show how the price level of this particular group of commodities has varied from 2005 to 2008. They show that prices were 29 per cent higher in year 2006, 56 per cent higher in year 2007 and 158.5 per cent in year 2008. The purchasing power of money over this group of commodities has fallen correspondingly. If we increase the list so far as to include the price relatives of all commodities and services, the index number obtained will show changes in the purchasing power of money because, the purchasing power of money is the inverse of the price level.
Table 40.1 Index Numbers
Weighted Index Numbers
An arithmetic average of price relatives as the one seen above, attaches equal importance to all the items of goods selected. But when constructing index number for particular purposes (e.g., calculating cost of living index number) all goods are not of equal importance. Surely, sugar is not as important as rice to a working class family. If between year 2005 and 2006, the price of rice rises by 50 per cent and that of sugar falls by 50 per cent the index number of year 2006 will remain unchanged but the cost of living is actually very much higher. This difficulty is solved by first finding out the relative importance of the four commodities given in the table above are in the rate of 8, 1, 5, 6. These numbers called “weights” are then multiplied with the corresponding price relatives and an average taken as shown in Table 40.2.
The figure 127 in Table 40.2 is called the weighted index number for the year 2009. There are different methods of selecting the weights. In the case of cost of living index numbers, the weights are obtained after a study of the working class budget.
Table 40.2 Weighted Index Numbers
|Commodity||Year 2009 Price relative * weight||Year 2010 Price relative * weight|
|Wheat||100 * 8 = 800||150 * 8 = 1,200|
|Oil||100 * 1 = 100||146 * 1 = 146|
|Vegetables||100 * 5 = 500||120 * 5 = 600|
|Transport||100 * 6 = 600||100 * 6 = 600|
|Total||100 * 20 = 2000/20||2546/20 =127.3|
|Average||100||127.3, i.e., 127|
Difficulties in the Construction
There are many difficulties in the construction of Index Numbers. Certain general difficulties in the construction of index numbers and the principles to be followed under such circumstances are given below.
- The choice of the base year: The base year is the year with reference to which price relatives are calculated. The base year must be a normal or average year, neither too prosperous nor too depressed. Generally, the year preceding a great disturbance is chosen as the base e.g., 1991 and 2001. As far as possible, the period taken as the base year should not be a too distant one as comparisons of two periods separated by a long gap will not be very useful. Sometimes, the average figure of a number of years is taken as the base. Sometimes, there is no fixed base. The figures of the previous year are taken as the base. Such index numbers are called chain index numbers.
- Selection of commodities: The selection of fairly representative commodities of the class of consumers may pose a problem as there is a very wide range of commodities people consume depending on their tastes, fashions, intensity of desires, etc. Besides, the number of commodities taken into consideration must be as large as possible.
- Collection of statistics: The statistics collected to be used in the construction of index numbers must be accurate. Problems often arise as to the type of figures that are to be taken into consideration—wholesale prices or retail prices in particular areas. Choice in such matters will depend on the purpose for which the index number is required. For the general price level, wholesale prices are more important, while for cost of living, index numbers retail prices are more relevant. Very often, statisticians resort to wholesale prices in constructing even cost of living index numbers. This will distort the result very much and show a lower price index as wholesale prices are lower compared to retail prices which are the ones at which people buy their goods.
Index numbers can be used for measuring all types of quantitative changes. Economic magnitudes such as prices, wages, imports, exports, production, employment and income are constantly changing. With properly constructed index numbers, we can compare these magnitudes for different times and different places and draw conclusions of economic importance. Decisions regarding economic policy must be based on the broad trends of factors such as prices, wages, etc. These trends can only be assessed with the aid of index numbers. Cost of living index numbers can be put to practical use in various ways. In some countries, they are related to wages. Wages are made to rise or fall with movements in the cost of living so that labour unrest may be avoided.
Despite all their advantages, index numbers must be used with caution. Index numbers are only approximations to truth and should be treated as such. Too much reliance on them will be misplaced as their construction presupposes so many assumptions. Too much importance must not be attached to them on account of the following reasons:
- Statistics are not always accurate: Index numbers based on false statistics are worse than useless. In developing countries like India, most of the statistical information available is inaccurate and manipulated.
- There are inherent defects in some types of index numbers: Incomes vary widely and different income groups have different consumption habits. Even within the same income level, there are different groups among whom the items consumed and their relative importance vary widely. There ought to be as many different cost of living index numbers as there are groups within the community. In practice, it would be difficult to construct so many index numbers.
- No inference should be drawn by comparing index number of years separated by a long period of time: The uniformity of basis essential for comparison between different years may not exist. Consumption habits and standard of living change in course of time. Methods of production and the types of goods produced do not remain the same. New commodities come into existence and old commodities disappear. These factors might be ignored in the short period. But long run comparisons (e.g., between 1951 and 2009) may be thoroughly misleading.
But, these deficiencies notwithstanding, index numbers are useful devices for trade unions in collective bargaining, industrialists in working out wages, prices, etc. and to common people in realizing the changes in the purchasing power of money. Governments have to use index numbers to take appropriate and suitable measures to prevent abrupt changes in the value of money.
THE CHANGING VALUE OF MONEY: INFLATION AND DEFLATION
Economies have always problems in managing stable prices over a period of time. Most of the time, there are aberrations either in the form of inflation or deflation, with adverse impacts on the polity and economy of the country. In the following pages, we will discuss inflation and deflation in greater depth and detail.
Inflation is the most experienced economic phenomenon in India and in the rest of the world. Though everyone, including economists, understands the gravity of the problem, nobody has a ready- made solution to combat it. Even world-famous economists like J. K. Galbraith have confessed their inability to provide a solution to the problems of inflation that could be implemented effectively in all countries. The phenomenon of inflation thus defies all economic explanations. Though some economists assert that inflation is a pure monetary phenomenon, it is commonsense knowledge that shortage of commodities, whether real or artificial and the consequent price rise can be attributed to more factors than one. Non-economic factors of psychology of consumers and sellers, government policies, transport problems, expectations regarding future supplies of goods, anticipated taxes, etc. all have significant impacts on price movements. In the following pages we will study inflation in all its aspects.
As commonly understood, inflation is said to exist when there is a rise in prices and a corresponding fall in the value of money. It is, however, difficult to give a generally accepted, precise and scientific definition of the term. As Meyers says, there are perhaps as many definitions of inflation as there are people who use the term.
Geoffrey Crowther defines inflation as a “State in which the value of money is, falling, i.e. prices are rising.”4 A. C. Pigou says, “Inflation is a situation in which the community's ‘money’ income increases faster than its ‘real’ income”.5 It is also stated that inflation arises when there is an increase in monetary unit without a corresponding increase in physical unit characterized by a general rise in the level of prices.
Most of the recent definitions, however, regard inflation as a purely monetary phenomenon and agree in substance that it is an expansion of money supply in excess of normal requirements. For instance, E. Thomas gives the definition of inflation as “abnormal expansion of currency and credit”, and to Sir Theodorc Gregory, a former adviser to the undivided government of India before partition, in his article on inflation defined it as “an abnormal increase in the quantity of purchasing power”.6 Ordinary expansion of currency to meet its demand in trade or to meet the needs of the increased population is not inflation as there is no change in the price level. Inflation is an over-expansion or excessive issue of currency on account of which prices rise and the value of money “depreciates”. In other words, as Coulborn said it is a case of “too much money chaseing too few goods”.7 Milton Friedman conceived inflation as a steady and sustained rise in prices and the final determinant of the level of prices is the stock of money. Thus, he stressed that inflation is always and everywhere a monetary phenomenon.
All these definitions are influenced by the quantity theory of money which regarded expansion of money as the cause, and the rise in prices the effect; but such an assumption is very much questioned by others who disprove it by empirical evidence. The case of inflation in Germany in the early 1920s showed that even when the quantity of money remained constant, prices could still rise as a result of increase in the velocity of circulation of money or shortage of essential commodities for home consumption. This type of inflation can never be attributed to rise in money supply. In recognition of this fact, Paul Einzig sets a distinction between money inflation and price inflation. To him, money inflation is the first stage of inflation in which excess of money over its normal requirements pushes up prices; and the price inflation is the stage that follows when prices rise with such staggering rapidity that money supply lags behind, that is, the rate of expansion of money supply fails to keep pace with its demand.
Though inflation is generally conceived as a monetary phenomenon, a group of economists including Pigou and Keynes regarded inflation as a phenomenon that follows full employment. According to them, a rise in prices in all situations cannot be termed as “inflation”. Keynes relates inflation to a rise in price level which comes into existence after the stage of full employment. In the early stages, expansion of money leading to an increase in demand will result not only in an increase in price level, but also in an increase in production and employment. This would continue till all unemployed factors of production found employment until the stage of full employment is reached. Beyond this stage, however, any increase in the volume of money, leading to an increase in demand, would lead only to a rise in prices but would not be accompanied by an increase in output and employment, as it is not possible to find employable factors to produce additional goods and services to absorb the extra money circulating in the economy. According to Keynes, it is the rise in prices after the stage of full employment is reached which can be described as inflation. Inflation occurs with an “an excess of demand for everything over the supply of everything”—it occurs because the limits of supply have been reached.
Broadly speaking, excess demand may be the result of upward shifts in demand or downward shifts in supply. Factors which cause an upward shift in demand, i.e., an increase in demand are (a) Rapidly growing public and private expenditure; (b) Reduction in taxation; (c) Relaxation of the borrowing programme of the government, and repayment of internal public debt and (d) Increase in the demand for exports.
A downward shift in supply, i.e., a decrease in supply, is influenced by factors such as (a) Shortage of factor supply; (b) Increased exports; (c) Diminishing returns or increasing costs and (d) Hoardings of commodities by both dealers and consumers. These situations leading to inflation may arise generally under the following circumstances:
- Periods when inflation is found fairly common: (a) During war time: When expenditure on war and war preparation is stepped up to a very high level with the sole intention of winning the war and at the same time restricting the output of consumer goods, there will arise a substantial increase in demand for various goods. Even during post-war periods, inflation may arise due to pent-up demand and the liability of a war-torn economy to supply civilian goods and services; (b) During the planning period: When the public sector investment or government expenditure on public programmes increases and the total demand rises, with the increased outlays. These economies are generally unable to increase their productivity as fast as demand for goods and services rises and ( c) When inventions and technological progress open up: Opportunities and investment expenditures of the entrepreneurs may increase and contribute to rise in demand when inventions and technological progress open up.
This means that inflation is usually war induced. Moreover, a situation of excess demand may also emerge when total supply decreases (either due to fall in productivity or obstacles in production, etc.) without a corresponding fall in demand.
- Demand-pull inflation: Generally in the quantity approach as well as in the demand approach to the level of prices, inflation is explained in terms of demand for goods and services. Demand for goods and services is said to rise faster than their aggregate supply either because of increase in income or increase in the volume of money. This pulls up the price level. This excess demand may have developed as a result of an increase in investment or expenditure in the public or private sector. In most cases, heavy government expenditure is incurred either for financing a war or for financing development projects.
- Cost-push inflation: This sort of inflation is also known as profit or wage-induced inflation. In certain circumstances, the rise in prices is brought about by an increase in the costs of production. Trade unions may press for wages that are higher than the productivity of workers. This rise in prices is followed by higher selling prices. Costs may also be raised by monopolies and others through a system of fixing a higher margin of profit. Rising rates of commodity taxes, in a period of sellers market will easily influence the producers to raise the prices by the full amount of taxes. Thus, rise in wages, in profit margin and in taxation are all responsible for cost-push inflation.
Inflation is a phenomenon that is observed only over a fairly long period. Inflation is always associated with rise in prices. In fact, it is a process of rising prices. Rise in prices has a spiralling effect in the sense that a rise in the price of one commodity will raise the prices of other commodities which in turn will accelerate the prices of still other commodities and so on. Inflation is also a monetary phenomenon; it is normally characterized by excessive money supply. Thus, the root cause of inflation is the expansion of money supply beyond the normal requirements. In reality, over-issue of paper money or undue expansion of bank credit has quite often been the initiating force behind inflation. The Indian inflation, for instance, can be traced to the government's excessive resort to deficit financing from 1956. Price rise during a period of inflation is persistent and cannot be arrested immediately. A temporary spurt in prices or an artificial shortage of commodities is not to be confused with inflation.
Types of Inflation
Inflation can be of various types, as described below:
- Currency inflation: The rise in price level may be the result of an excessive expansion of currency. Governments may increase money supply deliberately to raise prices and thereby revive trade and industry, when such a necessity arises.
- Credit inflation: The rise in prices may be traced to an expansion of bank credit. Banks may increase the volume of their loans in response to the demands of traders especially in times of business buoyancy.
- Deficit inflation: Under planning or under grave emergencies, the governments resort to deficit financing through creating new money. The result is that the purchasing power of the community increases and the prices may rise. This may be referred to as deficit-induced inflation. The prices rise due to deficit financing as the production of consumption goods fails to keep pace with the increased money expenditures.
Stages of Inflation
In the early stages of rise in price level, the rise in price is not very substantial. The prices rise very slowly and do not have a very serious effect on the economy. It is the mildest form of inflation. This is referred to as creeping inflation. This type of inflation, as some economists argue, is good for the economy because producers get more than the expected profits. This will induce them to invest more and produce more, employ more people, etc. The consumers also do not suffer much as they hardly realize the price rise while benefiting from rising production, employment, etc. But in course of time, when inflation becomes more marked, it is known as walking inflation. Walking inflation presents a red signal for the occurrence of running and galloping inflation. When the movement of price accelerates rapidly running inflation emerges. But when the rise in price level is staggering and extremely rapid it is referred as galloping inflation or hyper-inflation. Under hyper-inflation, prices rise every moment and there is no limit to the prise rise. At this stage, prices cannot be subjected to control.
Effects of Inflation
Changes in the value of money are harmful to society. Long and continued inflation disrupts society, and distorts the economy. It has social and political ramifications also. The adverse effects of inflation on the economic system may be classified as being of the following kinds: (i) Effects on production; (ii) Effects on distribution of income; (iii) Social and political effects and (iv) Other general effects.
Effects on production: Till the level of full employment is reached, gently rising prices are to some extent beneficial. This favourable impact on production is, however, possible only when inflation does not take place at too fast a rate. Running or galloping inflation creates uncertainty which will adversely affect production. When inflation has reached an advanced stage, its beneficial aspects disappear and the disadvantages of inflation are felt in the economy. These disadvantages are as follows: The orderly working of the economy through the operation of price mechanism is affected. This distortion of prices adversely affects the entire productive mechanism. Capital formation almost comes to a stop by an uncontrolled inflation. It also destroys the available capital resources. It drives them often out of the country, due to the falling purchasing power of money. People will have to spread out their incomes to buy commodities at higher prices than before. During such a period, savings are not available for accumulation of capital. Since excessive inflation disturbs all economic relationships and uncertainty prevails, the skill and energies of the business community are concentrated on speculation and making quick profits rather than on genuine productive activity. In addition to speculative activities, hoarding is also encouraged which further curtails the supply of goods. Since at these times the demand for goods increases, a phenomenon of black market develops ultimately.
Uncertainty of market conditions and the consequent risks involved during periods of inflation discourages entrepreneurs from producing for a distant future. This leads to a considerable decline in the volume of production. Moreover, resources are diverted from the production of essential goods to the production of luxury goods. This is because the rich whose incomes increase more rapidly than others demand luxury goods. Investments on undesirable lines are thus stimulated. With reduction in the volume of production and the persistent demand for goods, a sellers’ market develops. Anything that is produced can easily find a market. Producers will produce goods that are inferior in quality.
Effects on distribution: It is a notable feature of inflation that all prices (agricultural, industrial, wholesale, retail) do not move in the same direction and to the same extent. Changes in the price level would be of no economic significance if all individual prices were affected simultaneously and in the same proportion. Then each person would find that changes in costs of things to be purchased would be offset by proportional changes in the prices of the things he sold, leaving his economic position intact. It is because prices are not affected uniformly, that some classes of people are affected more adversely than others in a period of inflation. Inflation is a sort of hidden tax steeply regressive in its effects. Thus the redistribution in wealth involved in inflation lays a burden on those groups of people least able to bear it. In its redistribution effect, it will affect the following groups of people in different ways.
Business community: All producers, traders and speculators gain during inflation because of the emergence of windfall profits. Prices of goods rise at a far greater rate than costs of production; wages, interest rates, insurance premium, etc. are all more or less fixed as they were contracted earlier before the production of goods commenced. Further, the entrepreneur also gains on the stocks which he has been holding and which have appreciated in value. The business community, therefore, gets supernormal profits during inflation and these profits continue to increase so long as prices are rising. However, not all producers gain from inflation; the producers of conventionally priced goods and services such as electricity and transport services gain very little or not at all. This is so because the prices of their goods are fixed by convention or law. When prices in general rise, the costs of production of these commodities and services rise, but then prices remain more or less constant giving these producers a continuously decreasing margin of profit.
Fixed income groups: During times of inflation, wage earners and salaried people are the worst affected. If they try to push up their wages through labour unions, they bring about a cost-push inflation and their position is worsened in the long run due to unemployment and retrenchment. Those belonging to this group find their ‘real” income dwindling with the rapid rise in prices. However, these days, most of the wage earners are paid dearness allowances according to the cost of living Index Numbers that more or less neutralize their loss of purchasing power due to inflation. However, even in such cases, there is a time lag between the time they spend their incomes in a period of rising prices and the compensation granted by their employers, by which time prices would have still gone up. But other groups such as pensioners, receivers of fixed transfer incomes, etc. are badly hit by inflation.
Debtors and creditors: Investors in debentures and fixed interest-bearing securities lose during the period of inflation. However, investors in equities benefit. Middle class investors are likely to lose much as they invest their savings in fixed interest-bearing securities, insurance and savings accounts. People belonging to the renter class also suffer as their incomes are fixed in terms of money by contract for long periods. During inflation, debtors gain while creditors lose. Creditors lose because they are paid back dues in money which has less purchasing power. Debtors gain because they are paying back less in real terms.
Farmers: Farmers generally gain in times of inflation because prices of agricultural commodities which are essential items increase faster than other goods. But the prices and costs paid by them lag behind prices received. Additionally, farmers being a debtor class, they are in a position to discharge their debts in depreciated currency and thus derive a double advantage.
Social and political effects: Inflation in its redistributive effects causes great social injustice. It widens the gap between the “haves” and the “have nots” in the society. Inflation unduly favours the rich and the black marketeers. The standard of business morality declines as businessmen get ample chances of making profits through unfair means. Furthermore, inflation produces a “sellers’ market”. Since sellers can sell anything, the quality of goods produced often deteriorates and traders are inclined to adulterate products.
On the political front, inflation brings about, a weakness in political discipline. The increasing grievances and hardships of the masses in general on account of inflation may prepare them to revolt against the established society, social values and social order. It will create a great number of political tensions. Crime rates will increase. Corruption and malpractices in administration will become rampant.
To sum up, the consequences of inflation—inflation reduces savings, widens inequality of incomes and wealth, creates money illusion, real incomes get reduced, leads to industrial unrest, contract system fails, creditors lose, debtors gain; fixed income group lose, flexible income earners gain; farmers generally gain; rentiers, speculators and hoarders gain—thus generally adversely affect the most vulnerable sections of the population.
Control of Inflation
Inflation, if not controlled in its early stage, will take the shape of hyper-inflation which will completely ruin the economy. The different methods used to control inflation, known commonly as anti-inflationary measures, attempt mainly at reducing aggregate demand for goods and services on the basic assumption that inflationary rise in price is due to an excess of demand over a given supply of goods and services. Anti-inflationary measures can be put into three broad groups: (i) Monetary Policy (ii) Fiscal Policy and (iii) direct controls and other executive measures.
- Monetary Policy: The methods and devices used by central banks to bring appropriate changes in the supply of money and credit for ensuing monetary stability constitute what is called monetary policy. Central banks generally use three traditional weapons (i) Bank Rate Policy (ii) Open Market Operations and (iii) Variable Reserve Ratio. Monetary Policy to control inflation is based on the assumption that a rise in prices is due to a larger demand for goods and services. This is direct result of expansion of bank credit. Therefore, the aim of the central bank is to contract bank credit. Bank Rate Policy is the official rate at which the central bank lends money to banks against bills. The Open Market operations refer to the buying and selling of securities in the open market by the central bank to control the volume of credit. Alteration of cash ratio is a step by which the central bank by enjoining the banks to keep larger cash reserves with it against deposits restricts the base for credit creation. But the above-mentioned measures of credit control adopted by the central bank are not very effective due to various reasons. To this extent, monetary measures to control inflation are weakened. It is not always possible to control the rate of spending merely by controlling the quantity of money. There is no immediate and direct relationship between money supply and the price level as normally believed. However, it is more than likely that restriction in money supply along with other measures can play a decisive role in controlling inflation.
- Fiscal Policy: Fiscal Policy is a measure of control a government exercises through taxation; public borrowing and spending on the functioning of the economy. To combat inflation, fiscal measures would have to secure an increase in taxation and decrease in government spending. By reducing its expenditure on as many items as possible, the government tries to reduce pressures on prices arising from unregulated private spending. At the same time, to minimize inflationary pressures, the government would increase taxes—the purpose being to reduce the volume of purchasing power in the hands of the public and thus reduce their demand for goods. The tax policy should, of course, be directed towards restricting demand without adversely affecting production. This policy of increasing public revenue through taxation and decreasing public expenditure is known as surplus budgeting. But though it may be easy to increase revenue, it is difficult to decrease public expenditure especially expenditure on planned development.
Increase in voluntary or compulsory savings is another method of controlling inflation. Keynes has suggested a programme of compulsory savings like “forced savings”. However, such a scheme of compulsory saving may be easy to work during war time or during a post-war period when the pent-up demand of people and the incapacity of the war-torn economy to convert itself to peace time economy so that the “consumer goods can be produced, results in inflation. It is unworkable at other times. Lastly, public debt should be managed in such a way that the supply of money in the country is controlled. The government should avoid paying back any of its previous loans during inflation so as to prevent an increase in the circulation of money. Also, if the government manages to get a budgetary surplus, it should be used to cancel public debt held by the central bank. This might arrest the rising prices to some extent since money taken from the public and commercial banks is being cancelled out and is removed from circulation.
- Direct Controls: This executive policy refers to the regulatory measures adopted by a government to contain the harmful effects of inflation. Important among these measures is price control. This is an effective method during war time because both monetary and fiscal policies are more or less ineffective during this period. Price control means pegging down the prices (of goods) beyond which they should not rise. But this step is considered to be detrimental to the consumer's sovereignty, freedom and welfare.
Along with price control, the government also has to enforce rationing. The purpose of rationing is to distribute the goods which are in short supply in an equitable manner among all people irrespective of their wealth and social status. Price control and rationing generally go together. Their success, however, depends to a large extent on administrative efficiency.
Another device is to increase the supply of goods either through increased production, increased imports or decreased exports. Further, control of wages also becomes necessary to stop a wage-price spiral. Ceilings on wages and profits keep down disposable income and therefore the total effective demand for goods and services.
Deflation means a contraction of currency and credit leading to a fall in prices. It is the opposite of inflation, another extreme currency situation, where prices fall and the value of money rises. Deflation, according to Paul Einzig, “is a state of disequilibrium in which a contraction of purchasing power tends to cause, or is the effect of, the price level”.
Deflation is to be distinguished from Disinflation. The process of reversing inflation is called disinflation. Disinflation is said to take place when deliberate attempts are made to curb expenditures of all sorts and to lower prices and money incomes for the benefit of the community. Disinflation reverses inflation without creating unemployment or reducing output. Deflation, on the other hand, is that state of affairs in which every fall in prices increases unemployment, reduces output and curtails the income of the community. Thus, when prices fall below full-employment the situation is called deflation. Deflation may be due to a deliberate contraction of credit facilities by the monetary authorities or due to an automatic contraction of credit by the banks during a period of depression.
Deflation has an adverse effect on the level of production, business activity and employment. During deflation, prices fall because demand for goods and services is contracting. With a fall in prices, producers accumulate stocks, incur heavy losses and as a remedial measure retrench labour and reduce output. Pessimism grips the business community and investors and gradually a depressionary state of affairs develops in the economy.
Deflation affects adversely also the distribution of income. The share of profit earners in the total income declines while that of wage earners increases. Creditors gain while debtors lose because the latter repay their debts in appreciated currency. Fixed income earners gain. Thus, deflation benefits the middle class.
Control of Deflation
Anti-deflation measures are the opposite of those which are used to combat inflation.
- Monetary Policy: This will aim at controlling deflation through the use of discount rate, open market operations and other weapons of control available to the central bank of a country to raise the volume of credit of commercial banks. This policy is known as the cheap money policy. But as discussed earlier, monetary policy is weak, because even when commercial banks are prepared to lend more to businessmen to enable them to expand their investment, the latter may not be willing to do so for fear of possible failure of their investments.
- Fiscal Policy: This will be used to fight deflation through deficit financing. The government, on one hand, attempts to reduce the level of taxation and on the other hand, increases its expenditure on public work programmes, such as construction of parks, schools, dams, etc., which it would not have undertaken in normal time. This will provide employment, add to national wealth and counteract the deficiency of private demand and investment by means of an increase in government's demand for goods and services and also investment.
Other measures to control deflation include price support programmes and lowering of costs so as to bring about adjustment between price and cost of production. The government will have to fix prices below which commodities will not be sold and also undertake to buy surplus stocks.
Inflation Versus Deflation
From the analysis given above, one may be led to believe that inflation and deflation are exact opposites. But they are not. Inflation is a rise in prices unaccompanied by any appreciable increase in employment, while deflation is a fall in price accompanied by increasing unemployment.
Both inflation and deflation are socially bad, but inflation may be considered to be better of the two evils. Keynes stated: “Inflation is unjust, deflation is inexpedient. Of the two deflation is the worse.”
Inflation brings about a redistribution of income between different groups of people in the country. This redistribution is done in such an unjust manner that the rich gain at the expense of the poor. Deflation, on the other hand, reduces national income through reduction in the volume of production and much loss in employment. It adversely affects every group in the community. The entire community gets pauperized because of its maleficent effects.
Deflation increases the level of unemployment in the economy, whereas inflation at least implies that all factors are employed in some way or the other.
Inflation can be curbed to a large extent; only occasionally does it get out of control when the government fails to adopt appropriate monetary and fiscal policies. But deflation, when once started, injects so much pessimism into businessmen and bankers that it is very difficult to control it. Monetary policy becomes useless during such pessimism. No amount of increase in money supply can revive the price level and business expectations in the economy during depression.
However, there is nothing to choose between the two and the proper objective should be to aim at economic stabilization at the level of full employment.
Case 40.2 Inflation at Its Terribly Inflated Level!
Almost all countries of the world have been going through inflation at different points of time. There are many reasons as to why this happens, as explained in the text on Inflation. In recent times, economists have identified a strong positive correlation between global oil prices and global inflation. For example, in two episodes of oil shock in the 1980s and 1990s, global inflation surged. CPI in the industrial countries surged as high as 10 per cent in the early 1980s and reached 5 per cent in early 1990s. In the developing countries, inflation was worse when the CPI increased by 26 per cent in the early 1980s and 68 per cent in the 1990s.1 In November 2008, inflation was at 11-year high in China, 14-year high in Switzerland, 16-year high in Saudi Arabia and 25-year high in Singapore. In India, it has risen above 11 per cent, its highest rate in 13 years. This is more than 6 per cent higher than a year earlier and almost three times the RBI's target of 4.1 per cent. However, unlike in other countries, inflation in India is measured by Wholesale Price Index (WPI).
But the most telling case is that of Zimbabwe. Zimbabwe, the once rich African nation, has the dubious distinction of having the highest inflation rate in the world, with the official inflation rate at 2.2 million per cent. It has seen an unprecedented economic meltdown since it gained independence in 1980, because of years of political upheaval and economic turmoil that disrupted farming and industrial production and left a meagre 5 per cent of population in formal jobs. As a consequence, depleting production and fast declining government revenues, flight of foreign capital and a steep increase in money supply aggravated the inflationary spiral, triggered by increasing velocity of money.
Zimbabwe's government had printed trillions of new Zimbabwean dollars to keep ministries functioning and to shield the salaries of key supporters against further erosion and tripled the salaries of 190,000 soldiers and teachers. But even those government workers still badly trailed inflation; the best of the raises, to as much as $33 million a month, already were slightly below the latest poverty line for the average family of five. In January, the government issued bills in denominations of $1 million, $5 million and $10 million; and in May, it issued bills from $25 million and $50 million up to $25 billion and $50 billion.2 These new bills were actually bearer cheques that expired on 31 December. Zimbabwe did not have formal currency since the introduction of bearer cheques as a temporary measure in 2003.
In February 2008, government printed more than $ 21 trillion in currency to buy the American dollars with which the debt was paid. Zimbabwe's troubled central bank introduced $100 billion banknotes in a desperate bid to ease the recurrent cash shortages plaguing the inflation-ravaged economy. As high as they were, though, these bills still weren't enough to buy a loaf of bread. They could buy only four oranges. The new note was equal to just one USD. Zimbabwe knocked 10 zeroes off the country's hyper-inflated currency in August, making 10 billion dollars 1 dollar. One week earlier, the central bank introduced a new 100 billion-dollar note that is not enough to buy a loaf of bread. On 1 August, 2008, the bank issued a 500-dollar bill equivalent to 5 trillion dollars at the current rate. Computers, electronic calculators and automated teller machines at banks have not been able to handle basic transactions in billions and trillions of dollars.3
Presently, everyone in Zimbabwe is a billionaire, even beggars on the streets ask only for millions or billions. In Zimbabwe, toilet paper cost $417 while a roll cost $145,750—in American currency, about 69 cents. For millions of Zimbabweans, toilet paper, bread, margarine, meat, even the once ubiquitous morning cup of tea became unimaginable luxuries. They could hardly buy a single bread loaf or 3 eggs for 100 billion Zimbabwe dollar. All these were the outcomes of the hyper-inflation that was roaring ahead unabated.
High inflation adversely impacted economic growth because interest rates had to be raised significantly to contain price pressures. Some of the recent empirical studies show that global growth would be shaved by 0.5 per cent for every USD 10 increases in oil prices. It was the oil shocks that contributed to each one of the United States and global recessions of the last 30 years.4
Zimbabwe's inflation is hardly history's worst. In Weimar Germany in 1923, prices quadrupled each month, compared with doubling about once every 3 or 4 months in Zimbabwe. In war zones, as was seen recently in LTTE-controlled area in Sri Lanka, prices tend to soar. However, Zimbabwe's inflation is currently the world's highest, and has been there for some time.
2 CNN, “Zimbabwe Introduces $100 billion Banknotes”, CNN.com, Harare, Zimbabwe (CNN), http://edition.cnn.com/2008/world/africa/07/19/zimbabwe.banknotes/index.html.
- The first stage in the evolution of money was the barter system, where goods were exchanged for goods. The barter system was given up and the system of commodity-money was adopted by the people. Commodity money was replaced by metallic money. Paper money was used along with metal coins for smooth transactions. The last stage in the evolution of money is bank money which is known as credit money. Whatever is generally acceptable as a medium of exchange is money. Other functions of money are: (i) It serves as a measure of value; (ii) It serves as a store of value and (iii) It functions as a standard of deferred payments. The money can perform its functions effectively if it possesses the qualities like general acceptability, durability, divisibility, homogeneity, portability, recognizibility and stability of value. Money is generally divided into common money and bank money. Common money is money proper: currency notes and coins. Issue of paper money is based on fiduciary system. India follows minimum reserve system. Common money are further classified as limited legal tender and unlimited legal tender, standard money and token money.
- Gresham's law explains that bad money drives good money out of circulation when both are legal lender. The law does not operate when total supply of money is less than demand, when public opinion is against the use of bad money and when people are ignorant about the fact.
- The value of money refers to its purchasing power or the amount of goods and services a unit of money buys. Price indicates only the money value of a commodity and not its real value. Value of money is generally influenced by the demand for and supply of it. The demand for money is a derived demand. It is influenced not only by the transactions motive alone as contended by the classical economists but also by the precautionary and speculative motive as shown later by Lord Keynes. The supply of money refers to the total amount of money in circulation in an economy. The supply of money refers to the circulating media of cash and demand deposits and excludes the cash balances held by the central and state governments, central bank, treasuries, money held in bank by time and savings deposit-holders, stock of gold and other reserves that do not add to the circulating medium. Changes in the supply of money may arise over a moment of time and a period of time. When the supply of money relates to a moment of time, it is called monetary elasticity or the capacity of money to adjust itself in an appropriate manner to implied changes in the needs for money. When the supply of money is related to a period of time, it is called velocity of money or the number of time a unit of money changes hands.
- The quantity theory states the truism that other things being the same there is a direct relationship between the quantity of money and price level and inverse relationship between the quantity of money and its value. The assumptions of the Theory are unrealistic. An index number is a device used to show relative changes in prices or the value of money over a period of time. To construct an index number, we need to know the object, level of wages, list of commodities and their prices, the base year and the type of averages. Weighted Index Number is constructed by giving due importance to the commodities on the basis of their importance to consumers. Limitations of index numbers are mainly due to inaccurate statistics.
|bank credit||contingent functions||fiscal policy|
|intrinsic value||legal tender||metallic money|
|monetary policy||quantity theory||secondary functions|
|velocity of money|
- What are the inconveniences of the barter economy? How are they overcome by the introduction of money in modern economy?
- What are the advantages of a money economy over barter economy? Explain with reference to the functions of money.
- What are the main functions of money? Which of these is the most important in your opinion and why?
- Discuss the functions of money in a modern economy. What qualities should money possess to perform the functions satisfactorily?
- It is said that money is what money does. What does it really do? Discuss.
- To act as a medium of exchange is the main function of money. All the other functions flow from it. Examine this statement.
- Examine the role of money in a modern economy.
- Write short notes on: (i) Gresham's law, (ii) kinds of money and (iii) qualities of good money.
- Explain the validity of the following statements:
- Bad money drives good money out of circulation.
- The main characteristic that distinguishes money from all other economic goods is that it is universally accepted in discharge of debts. Whatever performs that function is, by definition, money.
- All functions of money are impaired, if money loses its value.
- What are the causes of price inflation? Is it inevitable in an economy?
- What is inflation? When does inflation set in? What monetary and fiscal measures would you recommend for controlling inflation?
- What are the economic consequences of inflation and deflation? Given a choice, which of these would you prefer?
- Discuss the causes of inflation. To what extent can monetary and fiscal measures control inflation?
- What are the traditional instruments of monetary policy? Examine their limitations in controlling inflation and deflation.
- What are the combative measures open to a government to fight inflation? Are these measures effective?
- What are the consequences of inflation? How does it affect the different sections of the community?
- Discuss the harmful effects of deflation. How does it affect production and distribution?
- What do you understand by the term “value of money”?
- Explain the concepts of “demand for money” and “supply of money”.
- What is an index number? How is it constructed?
- What is value of money? How is the value of money determined in an economy??
Chandler, L. V. Economics of Money and Banking. New York, N.Y., Harper and Row, 1981.
Government of India: Ministry of Finance, Economic Survey, 2007–08. New Delhi, 2008.
Government of India: Ministry of Finance, Economic Survey, 2008–09. New Delhi, 2009.
Halm, George N. Monetary Theory. Second edition. Philadelphia, P.A.: The Blakiston, 1942.
Narsimham Committee Report on the Financial System 1991. New Delhi: Standard Book Committee, 1992.
RBI: Final Report of the Committee to Enquire into the Securities Transactions of the Banks and Financial Institutions, Janakiraman Committee.
RBI: Review of the Working of the Monetary System, Chakravathy Committee Report, www.jstor.org/stable/4375200.
Robertson, D. H. and J. M. Keynes. Money. New York, N.Y.: Harcourt Brace and Company, 1922.