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MACRO ECONOMIC ISSUES

Demand for & Supply of Money

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MEDIUM OF EXCHANGE BARTER SYSTEM COMMODITY MONEY

TOKEN MONEY

Money is a commodity or token generally accepted as a medium of exchange by convention or law.

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FUNCTIONS OF MONEY

Primary Function Medium of Exchange

Secondary Function Unit of account Store of value Standard of Deferred Payment

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DEMAND FOR MONEY ( Motives for holding money) Transaction Demand for Money : positively related to real income and price level

Precautionary Demand for Money

Speculative Demand for Money : inversely related to interest rate

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Components of Money Supply

M1
M2

Currency with public+ Demand Deposits

M1 + Post Office Saving Deposits

M3
M4

M1 + Time Deposits with Bank

M3 + Total Post Office Deposits

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SUPPLY of MONEY Refers to the volume of money held by the public at any point of time. Money supply classification of sectors

Money Creating Sectors Government Commercial Bank Central Bank

Money Using Sectors Households Non Financial Enterprises

Financial Enterprises other than bank

Rest of the World
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Money Supply Process Supply of currency comes from monetary authorities Banks influences the money supply through the process of credit creation.

CENTRAL BANK BALANCE SHEET

Liabilities (Sources of funds) 1. Paid up Capital 2. Reserves 3. Currency with the public 4. Bank Reserves 5. Government Deposits 6. Other deposits Assets (Uses of funds) 1. Loans & Advances Government

Banks
Others 2. Investments Government Securities Foreign Assets 3. Gold (Monetary) 4. Government Currency Liabilities to Public 5. Other Assets
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Credit Creation Process

Suppose a bank receives a $100,000 deposit from one of its depositors. The bank is required to set aside 10% of this deposit, or $10,000, as reserves. It then lends out its excess reservesin this case, the remaining $90,000 of the initial deposit. Suppose, for the sake of simplicity, that all borrowers redeposit their loans into the same bank. The bank thus receives $90,000 in new deposits of which it sets $9,000 aside as reserves and lends out all of its excess reserves. Suppose again that all borrowers redeposit their loans in the same bank, that the bank sets aside a portion of these deposits, and that the bank then lends out the remainder, which is again redeposited in the bank and so on and so on. This repeated chain of events is summarized in Table .

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TABLE Multiple Expansion of Deposits Round New deposits New reserves New loans 1 2 3 4 5 . . . $100,000 90,000 81,000 72,900 65,610 . . + . $1,000,000 $10,000 9,000 8,100 7,290 6,561 . . + . $100,000 $90,000 81,000 72,900 65,610 59,049 . . + . $900,000

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Money multiplier. The amount by which bank deposits expand in response to an increase in excess reserves is found through the use of the money multiplier, which is given by the formula

In the example of deposit expansion found in Table , the reserve requirement is 10%; so, the money multiplier in this case is (1/.10) = 10. The excess reserves resulting from the initial deposit of $100,000 are $90,000. Multiplying $90,000 by the money multiplier, 10, yields $900,000, which is the amount of additional deposits created by the banking system as the result of the initial $100,000 deposit.

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