(b) GDP at FC (c) GNP at FC (d) GNP at MP 3. Net National Product at Factor Cost is also known as------------ (a) National Cost (b) National Income (c) Net Indirect Tax (d) Net Factor Income from Abroad 4. That part of personal income which is actually available to households for consumption and saving is called----------- (a) Personal Disposable Income (b) Personal Income (c) National Disposable Income (d) None of these 5. Sum of all kinds of income received by the individuals from all sources is called--------- (a) Personal Disposable Income (b) Personal Income (c) National Disposable Income (d) None of these Answers: 1. (a), 2. (c), 3. (b), 4. (a), 5. (b) REFERENCES • Dwivedi, D.N. (2006). Macroeconomics: Theory and Policy. New Delhi: Tata McGraw Hill. • Ray, N.C. (1980). An introduction to Macro Economics. New Delhi: The Macmillan Company 50 CU IDOL SELF LEARNING MATERIAL (SLM)
of India. • Lipsey, R.G. & Chrystal, K.A. (2004). Economics. New Delhi: Oxford University Press. • Shapiro, Edward. (2009). Macroeconomic Analysis. New York: Harcourt Publishers Ltd. • Peterson, L., Jain. (2005). Managerial Economic. New Delhi: Prentice Hall of India. • Mote, V.L., Gupta G.S. (2017). Managerial Economics. New Delhi: McGraw Hill Education. 51 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT 4- NATIONAL INCOME (MEASUREMENT METHODS) Structure Learning Objectives Introduction, Introduction to methods of calculating national income, i.e., Product method or value-added method, income method, expenditure method, Value-added method Income Method Final Expenditure Method Precautions to be taken while calculating national income The following are the precautions that should be taken into consideration while calculating national income using the value-added method The following are the precautions that should be taken into consideration while calculating national income using the income method The following are the precautions that should be taken into consideration while calculating national income using the final expenditure method Summary Key Words/Abbreviations Learning Activity Unit End Exercises (MCQs and Descriptive) References LEARNING OBJECTIVES After studying this unit, you will be able to learn: • Explain various methods of calculation of national income • List out the precautions to be taken while calculating it. 52 CU IDOL SELF LEARNING MATERIAL (SLM)
INTRODUCTION National income is the total money value of goods and services produced by a country in a particular period of time. The duration of this period is usually one year. National income can be defined by taking three viewpoints, namely production viewpoint, income viewpoint, and expenditure viewpoint. Based on these viewpoints, there are three different methods of estimating national income, which are shown in Figure-4.1: Table 4.1 Different Method of Measuring National Income For calculating national income-, an economy is looked upon from three different angles, which are as follows: 1. Production units in an economy are classified into primary, secondary, and tertiary sectors. On the basis of this classification, value-added method is used to measure national income. 2. Economy is also viewed as a combination of individuals and households owing different kinds of factors of production. On the basis of this combination, income method is used for estimating national income. 3. Economy is viewed as a collection of units used for consumption, saving, and investment. On the basis of this collection, final expenditure method is used for calculating national income. INTRODUCTION TO METHODS OF CALCULATING NATIONAL INCOME, I.E., PRODUCT METHOD OR VALUE-ADDED METHOD, INCOME METHOD, EXPENDITURE METHOD 53 CU IDOL SELF LEARNING MATERIAL (SLM)
Value-added Method: Value added method, also called net output method, is used to measure the contribution of an economy’s production units to the GDPmp. In other words, value-added method measures value added by each industry in an economy. For calculating national income through value- added method, it is necessary to first calculate gross value added at market price (GVAmp), net value added at market price (NV Amp), and net value added at factor cost (NVAfc). These can be calculated as follows: (i) GVAmp: Refers to the value of output at market prices minus intermediate consumption. The value of output can be calculated by multiplying quantity of output produced by a production unit during a given time period with price per unit. For instance, if output produced by a production unit in a year is 10000 units at price Rs. 10 per unit, then the total value of output would be 100000. The value of output is also calculated as: Value of output = Total Sales + Closing Stock – Opening Stock Where Net change in stock = Closing Stock – Opening Stock Glossing stock includes the value of unsold output in the previous year and forms the opening stock of the current year. Thus, by deducting the opening stock from the closing stock, unsold output of the current year can be calculated. On the other hand, intermediate consumption refers to the value of non-durable goods and services purchased by a production unit from another production unit in particular period of time. These goods and services used up or resold during that particular period of time. So, GVAmp can be calculated using the following formula: GVAmp = Value of Output Intermediate Consumption The word gross in GVAmp indicates the inclusion of depreciation. (ii) NVAmp: Excludes depreciation from GVAmp. In other words, NVAmp is GVAmp minus depreciation. (iii) NVAfc: 54 CU IDOL SELF LEARNING MATERIAL (SLM)
Refers to another measure of value added. It is calculated as: NVAfc = NVAmp Indirect Taxes + Subsidies Or NVAfc = GVAmp Depreciation Indirect Taxes + Subsidies Now, using the value-added method, we aim to calculate national income (NNPfc). The following are the steps to calculate national income using the value-added method: 1. Classifying the production units into primary, secondary, and tertiary sectors. 2. Estimating Net Value Added (NVAfc) of each sector. 3. Taking the sum of NVAfc of all the industrial sectors of the economy. This will give NDPfc. ΣNVAfc = NDPfc 4. Estimating NFIA and adding it to NDPfc, which gives NNPfc (national income). NDPfc + NFIA = National Income (NNPfc) Income Method: Income method, also known as factor income method, is used to calculate all income accrued to the basic factors of production used in producing national product. Traditionally, there are four factors of production, namely land, labor, capital, and organization. Accordingly there are four factor payments, namely rent, compensation of employees, interest, and profit. There is another category of factor payment called mixed income. These factor payments are explained as follows: (a) Rent: Refers to the amount payable in cash or in kind by a tenant to the landlord for using land. In national income accounting, the term rent is restricted to land and not to other goods, such as machinery. In addition to rent, royalty is also included in national income which is defined as the amount payable to landlord for granting the leasing rights of assets that can be extracted from land, for example, coal and natural gas. (b) Compensation of Employees: 55 CU IDOL SELF LEARNING MATERIAL (SLM)
Refer to the remuneration paid to employees in exchange of services rendered by them for producing goods and services. Compensation of employees is divided into two parts, which are as follows: (i) Wages and salaries: Include remuneration given in the form of cash to employees on a daily, weekly, or monthly basis. It includes allowances, such as conveyance allowance, bonuses, commissions, rent-free accommodation, loans on low interest rates, and medical and educational expenses. (ii) Social security contribution: Includes remuneration provided to employers in the form of social security schemes such as insurance, pensions, and provident fund. (c) Interest: Refers to the amount payable by the production unit for using the borrowed money. Generally, production units borrow for making investment and households borrow for meeting consumption expenditure. In national income accounting, interest is restricted to the payment by production units. If production units use their own savings, then the interest is payable to them in the form of imputed interest. (d) Profits: Refers to the amount of money earned by the owner of a production unit for his/her entrepreneurial abilities. The profits are distributed by the production unit under three heads. First is by paying income tax, called corporate profit tax. Second is by paying dividend to shareholder. Third is the retained earnings called undistributed profits. Thus, profit Is the sum total of corporate profit tax, dividend, and retained earnings. (e) Mixed Income: Refers to earnings from farming enterprises, sole proprietorships, and other professions, such as medical and legal practices. In these professions, owners themselves assume the role of an entrepreneur, financier, worker and landlords. Mixed income also takes into account the income of those individuals who earn from different sources, such as wages rents on own property, and interests on own money. Therefore, 56 CU IDOL SELF LEARNING MATERIAL (SLM)
National Income Rent + Wages + Interest + Profit + Mixed Income Now, let us discuss steps involved in estimating national income using the income method. These steps are as follows: 1. Classifying the production units into primary, secondary, and tertiary sectors. 2. Estimating Net Value Added (NVAfc) of each sector. The sum total of the factor payments equals NVAfc. 3. Taking the sum of NVAfc of all the industrial sectors of the economy. This will give NDPfc. ΣNVAfc = NDPfc 4. Estimating NFIA and adding it to NDPfc, which gives NNPfc (national income). NDPfc + NFIA = National Income (NNPfc) Final Expenditure Method: Final expenditure method, also known as final product method, is used to measure final expenditures incurred by production units for producing final goods and services within an economic territory during a given time period. These expenditures are incurred on consumption and investment. This method is the opposite of the value-added method. This is because value-added method estimates national income from the sales side, whereas the expenditure method calculates national income from the purchase side. Final expenditure of an economy is divided into consumption expenditure and investment expenditure, which are explained as follows: (a) Consumption Expenditure: Includes the following: (i) Private Final Consumption Expenditure (PFCE): Includes expenditure incurred by households and expenditure incurred by private non-profit institutions serving households (PNPISH). Thus, PFCE is divided into two parts, namely Household’s Final Consumption Expenditure (HFCE) and PNPISH Final Consumption Expenditure (PNPISH-FCE). HFCE is defined as expenditures, both actual and imputed, incurred by a country’s households on final goods and services for satisfying their wants. In addition to actual money 57 CU IDOL SELF LEARNING MATERIAL (SLM)
expenditure, HFCE includes imputed value of goods and services received without incurring money expenditure, for example, self-consumed output and gifts received in kind. Expenditure by non-residents of a country is not included in HFCE. However, the expenditure incurred by the national residents in foreign countries is included in HFCE. Thus, imports are the part of HFCE. In addition, HFCE excludes the receipts from the sale of pre- owned goods, wastes, and scraps. HFCE can be calculated with the help of the following formula: HFCE = Money expenditure on consumption by residents + Imputed value of consumer goods and services received in kind by residents – Sale of pre-owned goods, wastes, and scraps On the other hand, PNPISH includes expenditure incurred by private charitable institutions, trade unions, and religious societies, which produce goods and services to be supplied to consumers either free or at token prices. PNPISH-FCE = Imputed value of goods and services produced Commodity and non- commodity sales Commodity sales imply the sale at a price that covers cost, while non-commodity sales imply the sale at a price that does not cover cost. (ii) Government Final Consumption Expenditure (GFCE): Includes expenditure that is incurred by government for providing free goods and services to citizens. GFCE is equal to value of output minus sales (GFCE = Value of Output – Sales). The value of output is calculated as: Value of output generated by government = Compensation of government employees + purchases of commodities and services + consumption of fixed capital Sales by government = Commodity Sales + Non- Commodity Sales (b) Investment Expenditure: Involves expenditure incurred on capital formation. This expenditure is known as Gross Domestic Capital Formation (GDCF). There are three components of GDCF, which are as follows: (i) Acquisition of fixed capital assets: Implies purchasing assets, such as building and machinery. 58 CU IDOL SELF LEARNING MATERIAL (SLM)
(ii) Change in stocks: Involves making addition to the stock of raw materials, semi-finished goods, and finished goods. (iii) Net acquisition of valuables: Involves acquisition of valuables minus disposal of valuables. These valuables include precious stones, metals, and jewellery. GDCF becomes net when it is diminished by depreciation. Net GDCF = GDCF – depreciation GDCF is subdivided into Gross Domestic Fixed Capital Formation (GDFCF) and change in stocks. Now, let us discuss steps involved in estimating national income using final expenditure method. These steps are as follows: 1. Classifying the production units into primary, secondary, and tertiary sectors. 2. Estimating the final expenditures on goods and services by industrial sectors. These expenditures are PFCE, GFCE, and GDCF. The expenditure also includes net exports, which are equal to exports minus imports. 3. Taking the sum of the final expenditures which gives GDPmp. GDPmp = PFCE + GFCE + GDCF + Net Exports 4. Estimating the consumption of fixed capital and net indirect taxes to calculate NDPfc. NDPfc = GDPmp – Consumption of Fixed Capital- Net Indirect Taxes 5. Adding NFIA to get national income (NNPfc) NDPfc +NFIA = NNPfc PRECAUTIONS TO BE TAKEN WHILE CALCULATING NATIONAL INCOME The following are the precautions that should be taken into consideration while calculating national income using the value-added method: i. Avoiding double counting of output as it leads to the overestimation of national 59 CU IDOL SELF LEARNING MATERIAL (SLM)
income. For example, a farmer produces 5 kilograms of wheat worth Rs. 10000. He sells this wheat to a baker who uses it for making breads. The baker further sells these breads lo a grocer for Rs. 20000. Finally, the grocer sells these breads to consumers for Rs. 25000. Thus, the total output of the farmer, baker, and grocer would be Rs. 55000. However, this cannot be taken as the value of actual physical output. This is because it includes the value of wheal three times and value of bread two times. The double counting can be avoided by two measures. First is by taking the total value added instead of taking the total output. In the above example, the value added by farmer is nil, by the baker is Rs. 10000, and by the grocer is Rs. 15000. Thus, the sum total of value added is Rs. 25000. Second is by taking the value of final products only. Final products are those which are purchased for consumption and investment. In the above example, the final product is bread sold to the consumers for Rs. 25000. Thus, the final output is Rs. 25000. ii. Including output produced by production units for self-consumption in total output. All the production should be included whether u is sold in the market or not. In addition, the value of free services provided by government and non-profit institutions should also be taken into account. Non-inclusion of these will lead to underestimation of national income. iii. Avoiding the inclusion of sales of pre-owned goods. This is because these goods are already counted when sold for the first time. The output of only newly produced goods is included in total output. However, the value of services provided by agents in selling pre-owned goods is fresh output and should be included in the total output. The following are the precautions that should be taken into consideration while calculating national income using the income method: a. Including the imputed value of factor services rendered by the owners of production units themselves. For example, if production units use their own savings for production, then the interest is payable to them in the form of imputed interest. This imputed interest should be added in the calculation of national income. b. Avoiding the inclusion of transfer payments, such as gifts, donations and taxes. c. Excluding the gains that arise from the sales of pre-owned goods. These gains are called capital gains. d. Excluding the income arising from sale of financial assets, such as shares and 60 CU IDOL SELF LEARNING MATERIAL (SLM)
debentures. This is not related to the production of goods and services. However, national income includes the value of services rendered by the agents in selling these financial assets. The following are the precautions that should be taken into consideration while calculating national income using the final expenditure method: a. Excluding the intermediate expenditure as it is already a part of final expenditure b. Including the imputed expenditure incurred for producing goods for self-consumption c. Excluding the expenditure incurred on transfer payments d. Excluding expenditure incurred on financial assets, such as shares and debentures e. Excluding the expenditure incurred on pre-owned goods SUMMARY Table-4.2 shows the summarize calculation of national income by three methods: Table 4.2 Calculation of National Income by three Methods National income accounting is a double-entry accounting system used by the government to measure how well a country’s economy is performing. • The value-added approach, income approach, and expenditure approach are different ways to calculate national income. They can be used in combination, depending on the concerned income group and sector. • The statistics provided by national income accounting can be used by the government to set or modify economic policies, interest rates, and monetary policy. • The statistics provided by national income accounting can be used to simplify the procedures and techniques used to measure the aggregate input and output of an 61 CU IDOL SELF LEARNING MATERIAL (SLM)
economy. The data provided is used to frame government economic policies, and it also helps in recognizing the systemic changes happening in the economy. • National income accounting provides information on the trend of economic activity level. Various social and economic phenomena can be explained through the data, which helps the policymakers in framing better economic policies. Central banks can use the national income accounting statistics to vary the rate of interest and set or revise the monetary policy. • The data on GDP, investments, and expenditures also helps the government to frame or modify policies regarding infrastructure spending and tax rates. The national income accounting data also shows the contribution of different sectors, relative to each other, towards economic growth. KEY WORDS/ABBREVIATIONS • Profits - The difference between sales revenue and the costs of production. • Rationing Systems - A process used to match the desire for goods and services with their availability. • Resources - The raw materials and other factors of production that enter the production process or final goods and services that are desired by economic agents. • Revenue - The amount received by a producer from the sale of goods and services (the product of market price and quantity sold). • Scarcity- A physical or economic condition where the quantity desired of a good or service exceeds the availability of that good or service in the absence of a rationing system. LEARNING ACTIVITY 1. State the precautions that needs to be taken while calculating national income 2. Give the details of 3 methods of measuring NI UNIT END EXERCISES (MCQS AND DESCRIPTIVE) 62 CU IDOL SELF LEARNING MATERIAL (SLM)
A. Descriptive Type Questions 1. Note on expenditure method 2. Explain the income method 3. What does one mean by expenditure method? 4. Note on the factor incomes 5. State the precautions that needs to be taken while calculating national income using Income method. B. Multiple Choice Questions 1. Product method of calculating national income is also known as: (a) Value added method (b) Income method (c) Expenditure method (d) Distribution method 2. Commodity service method is also known as (a) Income method (b) Expenditure method (c) Distribution method (d) Value added method 3. The word gross in GVAmp indicates the inclusion of (a) Net Profit (b) Taxes (c) Depreciation (d) None of these 4. , also known as factor income method 63 CU IDOL SELF LEARNING MATERIAL (SLM)
(a) Value added method (b) Income method (c) Expenditure method (d) Distribution method 5. also known as final product method (a) Income method (b) Expenditure method (c) Distribution method (d) Value added method Answers: 1. (a) 2. (d) 3. (c) 4. (b) 5. (b) REFERENCES • Dwivedi, D.N. (2006). Macroeconomics: Theory and Policy. New Delhi: Tata McGraw Hill. • Ray, N.C. (1980). An introduction to Macro Economics. New Delhi: The Macmillan Company of India. • Lipsey, R.G. & Chrystal, K.A. (2004). Economics. New Delhi: Oxford University Press. • Shapiro, Edward. (2009). Macroeconomic Analysis. New York: Harcourt Publishers Ltd. • Peterson, L., Jain. (2005). Managerial Economic. New Delhi: Prentice Hall of India. • Mote, V.L., Gupta G.S. (2017). Managerial Economics. New Delhi: McGraw Hill Education. 64 CU IDOL SELF LEARNING MATERIAL (SLM)
65 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT 5- MONEY AND BANKING Structure Learning Objectives Introduction, Meaning of supply of money, Currency held by the public and net demand deposits held by commercial banks High powered money & measurement of money supply Supply of Money – Its Main Components Paper Currency Demand Deposits Sources of Money Supply Alternative Measures of Money Supply (Money Stock) Money creation by the commercial banking system Why only fraction of deposits is kept as Cash Reserves? Money Multiplier: Central bank and its functions Functions of Central Bank Structure of RBI Establishment of RBI Central board of directors consists of Organization Structure Objectives Major Functions of RBI Electronic Payments Control of Credit and its tool (Monetary Policy) The main objectives of Monetary Policy The two types of instruments of the monetary policy 66 CU IDOL SELF LEARNING MATERIAL (SLM)
Summary Key Words/Abbreviations Learning Activity Unit End Exercises (MCQs and Descriptive) References LEARNING OBJECTIVES After studying this unit, you will be able to: • Describe the currency creation concepts • Explain the structure of central bank • Explain the Reserve Bank of India & its functions & the organization structure in detail INTRODUCTION Money is the habitually accepted mode of exchange. In an economy which comprises of only one individual, there cannot be any exchange of goods and therefore there is no part for money. Money is anything that is generally accepted as a means of exchange and at the same time; act as a measure and as a store of value. Economic exchanges without the conciliation of money are known as barter exchanges or barter systems. However, they presume the rather unlikely double coincidence of wants. Contemplate, for instance, an individual who has an excess amount of rice which he or she wishes to trade for clothing. If he or she is not fortunate enough, he or she may be unable to find another person who has the absolute opposite demand for rice with an excess of clothing to offer in exchange. The search costs may become restrictive as the number of individuals goes high. Hence, to smoothen the transaction, an intermediate commodity is necessary which is suitable and acceptable to both parties. Such a commodity is known as money. The individuals can then sell their products for money and use this money to buy the goods they need. Though the help of exchanges is contemplated to be the primary role of money, it serves other causes as well. Banking is a trade of accepting deposits and lending money. It is functioned by financial intermediaries, which executes the functions of shielding deposits and furnishing loans to the public. To put it in other words, banking means accepting for the cause of lending or investment of 67 CU IDOL SELF LEARNING MATERIAL (SLM)
deposits of money from public outstanding on-demand and can be withdrawn by cheque, draft order. MEANING OF SUPPLY OF MONEY Money supply means the total amount of money in an economy. The effective money supply consists mostly of currency and demand deposits. Currency includes all coins and paper money issued by the government and the banks. Bank deposits (payable on demand) are regarded part of money supply and they constitute about 75 to 80 per cent of the total money supply in the US. Some economists also include near money, or such liquid assets as savings, deposits and government bills in the money supply. The total supply of money is determined by banks, the Federal Reserve, businessmen, the government and consumers. For theoretical purposes money is defined as any asset which performs the functions of money—but in actual practice, there are many financial assets which perform these functions to a greater or lesser degree and this makes it difficult to measure empirically the magnitude of money. It should be noted that ‘money supply’ which refers to the total stock of domestic means of payment owned by the ‘public’ in a country, we consider the stock of money in spendable form only to be the main source of money supply. In other words, the cash balances held by the central and state governments with the Central Bank and in treasuries are generally excluded on the ground that they arise out of the non- commercial, particularly administrative operations of the government. Thus, the ‘quantity of money’ means the ‘total amount of money in circulation’ in existence at a time. Money is something which is measurable. Supply of money refers to its stock at any point of time; it is because money is a stock variable as against a flow variable (real income). It is the change in the stock of money during a period (say a year), which is a flow. The stock of money always refers to the stock of money held by the public. Throughout history the question of not only what constitutes money but where it comes from has been both important and controversial. In contrast to income, which is measured over time; the money is a stock, not a flow. Since money is a stock, it means that the amount of money in existence at any point of time must be held by some entity in the economy. Economists make a distinction between amount of money in existence at any point of time and the amount that people and institutions may want to hold for various reasons. When the amount of money actually being held coincides with the amount of money individuals, business houses and governments actually want to hold; a 68 CU IDOL SELF LEARNING MATERIAL (SLM)
condition of monetary equilibrium exists. A distinction must be made between the current deposits or current accounts of banks which have the status of money and deposit accounts (fixed or savings deposits) which do not have the status of money and are at best regarded quasi-money or near money. The reason being that time deposits of commercial banks can be drawn only at the end of a fixed period or earlier by paying a penalty or by obtaining prior permission. These are no doubt a store of value but are not the means of payment but only equivalent to means of payment. These are no doubt liquid assets but they are not so liquid enough as to rank as money. What distinguishes these deposits is the fact that they earn an interest income and can be converted as means of payment only after some delay and not at once. As such, these time and saving deposits are excluded from the pool of the money supply. However, alternative definitions of money have been adopted by many writers. Notably, the Chicago School led by Milton Friedman opts to include all bank deposits, time and demand, in money supply. In fact, Schwartz and Friedman are willing to consider as money all marketable government securities which are supported at par. By the same logic, there is no reason why the liabilities of saving institutions should not also be included in money. The debatable question is whether the measure of money should be extended to include other deposits liabilities of the commercial banks, e.g., time deposits in USA and deposit accounts in the UK. Some investigators go further and include the liabilities of some other deposit taking institutions, such as savings and loan associations in the USA and saving banks in Britain, on the grounds that their fixed monetary value—and usually the ease of encashment—makes them good substitutes for interest bearing bank deposits. It has, therefore, to be observed that various measures of money supply keep on changing from country to country and from time to time within the country. As such, the measurement of money supply becomes an empirical matter. Up to 1968, the RBI published a single measure of money supply (called M and later on M1) defined as currency and demand deposits (dd), held by the public. It was called the narrow measure of money supply. After 1968 the RBI started publishing a ‘broader’ measure of money supply called aggregate monetary resources (AMR) defined as M or M1 plus the net time deposits of banks held by the public (M3). However, since 1977 RBI is publishing data on four alternative measures of money supply denoted by M1, M2, M3 and M4 as follows: M or M1 = c + dd + od M2 = M1 + Savings deposits with post office saving banks 69 CU IDOL SELF LEARNING MATERIAL (SLM)
(AMR) M3 = M1 + net time deposits of banks M4 = M3 + total deposits with post office saving banks. Where c stands for currency held by public; dd, net demand deposits of banks; od implies other deposits of the RBI. Currency includes paper currency and coins, that is notes issued by the RBI and one rupee and other small coins issued by the Government of India. Net demand deposits include deposits held by public and not inter-bank deposits—deposits held by one bank for another. These are not held by public hence excluded. Other deposits (od) of the RBI are its deposits other than those held by the government (Central and State Governments), banks, and a few others. These other deposits constitute very small proportion (less than one per cent) of the total money supply, hence could be ignored. Each definition of money supply from M1 to M4 has its adherents; but by and large most economists prefer the most common sense and most acceptable definition of money or money supply, that is, M1—because it includes everything that is generally acceptable as a means of payment but no more. Once you go beyond currency and demand deposits, it is hard to find a logical place to stop, since many things (bonds, stocks, debt instruments) contain liquidity in varying degree. It is better, therefore, to stick to M1 definition of money supply including currency plus all demand deposits. CURRENCY HELD BY THE PUBLIC AND NET DEMAND DEPOSITS HELD BY COMMERCIAL BANKS. High powered money and measurement of money supply: It should be noted that money supply is not always policy determined. In fact, money supply is determined jointly by monetary authority, banks and the public. It is true that the role of monetary authority is predominant in determining the supply of money. Two types of money must be distinguished: (i) Ordinary money (M) and (ii) High powered money (H). Ordinary money (M) as we have known is currency plus demand deposits: M = C + dd. On the other hand, high powered money (H) is the money produced by the RBI and the government of India (small coins including one rupee notes) held by the public and banks. The RBI calls it H ‘reserve money’. H is the sum of: (i) Currency held by public (c); 70 CU IDOL SELF LEARNING MATERIAL (SLM)
(ii) Cash reserves of the banks (R) ; and (iii) Other deposits of RBI (od), we can ignore item (iii) from theoretical discussion as it hardly constitutes one per cent of total H. Hence, H = C + R. Now, if we compare the two equations of two types of money ordinary money (M – C + dd) and high powered money (H = C + R), we find C is common to both ; the difference between the two M and H is due to dd in M and R in H. This difference is of vital importance. Banks are producers of demand deposits (dd) and these demand deposits are treated as money at par with currency (c). But to be able to create (or produce) dd; banks have to maintain R, which in turn, is a part of H, produced only by monetary authority and not by banks. We know in a fractional reserve banking system, dd are a certain multiple of R, which are a component of H; it gives H the quality of high powered-ness (high powered money as compared to M)—the power of serving as the base for multiple creation of dd. That is why, H is also called “base money’. H thus becomes the single most dominant factor of determining money supply—called H theory of money supply’—also called money-multiplier theory of money supply. The actual measurement of money in the modern economy has become an extremely complex matter because a fairly large variety of financial assets exist in the economy that serves as money in one way or another. Before the growth of a large variety of ‘near monies’, the circulating media (ordinary money M) could be described adequately by the term‘deposit money’ or ‘deposits’, since a good part of the ordinary money (M) that actually circulated in the economy consisted of demand deposits in ‘nations’ commercial banks. But it is too restricted now on account of the growth of new varieties of near monies. Monetary base which is also called central bank money—consists of all reserves of financial institutions on deposit with the central banks and all currency in actual circulation or in the vaults of commercial banks. This central bank or base money which is also called ‘high powered money’ is the primary means through which the central bank can influence the total money supply in the economy. It is also called high powered because every unit (rupee) of central bank money provides a support base for several units (rupees) of money in actual circle. The monetary base is important because changes in it have the power to produce multiple changes circulating money. The size of the monetary base in turn changes or fluctuates with changes in asset and liabilities of the central bank. Thus, what the central bank has under its control is the size of money base (central bank money)—Whether or not changes in the monetary base actually lead changes in money in circulation depends upon how the public (including banks and other finance institutions) 71 CU IDOL SELF LEARNING MATERIAL (SLM)
react to such a change. It is for public to decide whether or not to change its holdings currency, deposits and financial assets that serve as money in response to change in monetary base. Hence, the link between monetary base and the total money in circulation is a real one; though it is not an exact and mechanical one. Thus, let it be clear that: (i) The total supply of money or stock is determined by the behavior of banks intheir decision concerning the size of reserve ratio they wish to maintain, (ii) By the behavior of the non-bank public in their decision to divide their money balances between currency and demand deposits at commercial banks; and (iii) By monetary authorities in their decision to change the size of the monetary base and the exercise of their legal authority to set the minimum amount of reserves banks must hold. It is, therefore, clear that interactions among the actions of the public, the banks and the monetary authorities (central banks) determine the money supply. Behavior of the public depending on currency deposit ratio C/D that of banks on reserve deposit ratio R/D and that of monetary authorities by the stock of high powered money or the monetary base H. However, keeping in line with the recent developments in monetary theory, it will be fruitful to adopt the narrow concept of money—currency plus demand deposits—based on the means of payment criterion which facilitates the formulations of a theory of asset choices. Further, it may also be noted what we exclude from the money supply of a country—the monetary gold stock which serves as international money and is not permitted to circulate within the country; as also we must exclude the currency and demand deposits owned by the treasury, the central bank, and the commercial banks, which are money issuing institutions holding these funds partly as reserves to support publically owned demand deposits. These exclusions are in order because their inclusion i.e., of both the cash holdings of money issuers and the monetary super-structure supported by these holdings would involve double counting. Thus, for all practical purposes, the money supply with public consists of currency (notes and coins) and demand deposits with banks. In the income and employment analysis quite often money supply is taken and as exogenous variable (depending on the administrative action of the central bank). This convenient simplification has been followed in the employment theory from time to time. But in actual practice the empirical studies on money supply data have shown that it is not at all necessary to assume that the money supply is exogenous—that is, unrelated functionally to other variables in the economic system. 72 CU IDOL SELF LEARNING MATERIAL (SLM)
The trend in recent analysis (especially after Friedman) is to treat money supply endogenously, as a variable functionally related to other variables in the economic system. A useful approach along those lines has been developed by Ronald Teigen (of University of Michigan). He suggests a money supply function that reflects both—the profit maximizing decisions of the commercial banks and the policy actions of the Central Bank. It is, therefore, clear that changes in H are policy controlled—while changes in M are largely endogenous, that is, are such as depend mainly on the behavioral choices of the public and banks. That is why it is said that monetary authority will do well to consider M as something outside its control and concentrate its efforts to control H in order to control M. Efforts to control M directly except through H route (or base money) are bound to prove self-defeating. Supply of Money—Its Main Components: It is by now clear that the main components of the supply of money are coins (standard money): paper currency and demand deposits or credit money created by commercial banks: The term ‘Monetary Standard’ refers to the type of standard money used in a monetary system. As a matter of fact, the monetary system of a country is generally described in terms of its standard money. The monetary standard, therefore, is synonymous with the standard money. (Monetary system consists of its standard money plus all the paper and credit substitutes tied to and convertible into standard money). When the standard monetary unit is gold, a country is said to have a gold standard system; if the standard monetary unit is defined in terms of both gold and silver, the system is one of bimetallism. If, however, a country’s currency is not convertible in either gold or silver, it is said to be an inconvertible paper money standard. Thus, it is customary to describe the monetary system of a country in terms of its standard money which constitutes the chief source of its supply. It may be noted that the adoption of a particular monetary standard in a country at a particular time, depends upon the economic conditions prevailing there. However, monetary standard which, thus, becomes an essential part of the monetary system, has to be such as will facilitate elastic money supply, economic development and promote the welfare of the people. A suitable monetary system is one which satisfies both domestic requirements and the necessities of international trade. Generally speaking, the monetary system and, therefore, the monetary standards are guided by internal needs of a particular country, though the international aspects of currency management cannot be ignored. Countries are no more closed economies. A good money supply system is based on good monetary standard; it must be certain inasmuch as its rules should be clear to the public; 73 CU IDOL SELF LEARNING MATERIAL (SLM)
simple in working and should be able to create confidence in the public mind besides being economical. Moreover, a good monetary standard or money supply system, should ensure automatic working and control over excessive issue of money supply. Further, it has to be elastic so that currency can expand and contract according to the requirements of the economy and, above all, it should be able to secure stability of prices as well as rates of exchange. It is, however, difficult to find a unique monetary standard or money supply system which entirely satisfies both domestic and international requirements of money supply. It has, therefore, assumed different forms from time to time. The standard money or a system of money supply, when it consisted of gold coins took the form of either gold coin standard or gold bullion standard or gold exchange standard. A comparative study of their features is given in the table below: Table 5.1 a comparative study of their features Thus, a comparative study of the features of the three variants of the gold standard would convince anyone about the efficacy of the post war gold standard variants (gold-exchange standard and gold-bullion standard) and the system of money supply based on it. Gold- exchange standard is said to have, more or less, the same uses as the gold-coin standard, at the same time economizing the use of gold and freeing the authorities from the botheration of 74 CU IDOL SELF LEARNING MATERIAL (SLM)
coinage. This made it possible for the poor countries to reap the benefits of gold-coin standard and was more in accordance with the monetary environment prevailing in the post-World War, though such a system of money supply called for greater monetary management. It is rather difficult for any one variant of the gold standard to claim undisputed supremacy regardingthe regulation of money supply and its control. Having dismissed bimetallism as the standard which does not merit serious consideration, gold-coin standard was strongly favored. Though a causality of the two World Wars and the Great Depression, it still commands respect and even liking in certain circles, leaving the choice in favor of a particular variant under the circumstances prevailing in a country. However, modern system of money supply is primarily based on managed currency system. Paper Currency: The paper currency also described as the managed currency standard or the fiat standard, refers to a monetary system in which the standard currency of the country in circulation consists mainly of paper money. Paper standard or the fiat standard as distinguished from metallic standards is essentially the by-product of the World War I, for, before that, world currencies consisted mainly of full-bodied coins made of silver or gold or both. The period following the World War I ushered in an era of inconvertible paper money. The paper standard or the fiat standard or the managed standard is distinct from other monetary standards inasmuch as, under it, there is no convertibility of the paper currency in any metal. As a result, the volume of paper currency is determined by the considerations of convenience and economic activities rather than by the volume of metal. Moreover, paper currency system is nationalistic as there is no common link between the different currency systems. Thus, the important features of paper currency standard are: 1. Paper money is the standard money and is accepted as unlimited legal tender in the discharge of obligations; 2. Paper money is not convertible into gold or any other metal; 3. The volume of paper currency is controlled by the monetary authority (central bank), which expands or contracts the currency according to the requirements of the economy; 4. Though the standard money is made of paper, there may be in circulation metallic coins also being unlimited legal tender; 5. For purposes of foreign trade the rate of exchange is determined on the basis or parity 75 CU IDOL SELF LEARNING MATERIAL (SLM)
between the purchasing power of the currencies of the respective countries. Suppose one dollar in the United States has the same purchasing power is hundred francs in France, then one dollar will be equal to 100 francs. Since the intrinsic value (real value) of paper money is less than its value as money (face value) and further as it is not convertible into some other form of metal money, it is also referred to as fiat money and the standard as fiat standard. Moreover, the quantity of money in circulation is regulated and managed by the appropriate monetary authority in the country with a view to bringing stability in prices and incomes; therefore, it is also called managed currency system. The backbone of the currency system is the central bank notes and coins because centralbank has the monopoly of note issue, though in certain countries the treasury also issues notes or coins along with the central bank. In India, for instance, one rupee notes are issued and managed in circulation by the government of India, Ministry of Finance, and the rest of the notes and coins are issued and managed by the Reserve Bank of India. Supply of paper money in the country is governed by the system laid down for the purpose. Broadly speaking, there are three important methods of note issue: (i) The fixed fiduciary system, (ii) The proportional reserve system, and (iii)Minimum reserve system. The first one is in vogue in UK and the second one is prevalent in USA and the third one in India at present. In India proportional reserve system also prevailed up to mid-1950s. Then the minimum reserve system replaced it. How much currency of particular denomination will be in circulation and its proportion to the total money supply are governed by the actions of the public. The treasury, the commercial banks and the central bank are the agencies through which the preference of the public is expressed. According to the Board of Governors of the Federal Reserve System, “Neither the central bank nor the treasury has under ordinary circumstances any direct way of keeping in circulation a larger amount of currency than the public requires or of reducing the amount of currency that the public needs to finance its current operations”. The desire of the public to hold more or less currency or more or less of particular denominations is normally influenced by many factors like the volume of trade, nature of trade—whether wholesale or retail price level, methods of payments, banking habits of public, volume of demand deposits, volume of transactions, distribution of national income, methods of taxation, public loans, deficit financing, etc. 76 CU IDOL SELF LEARNING MATERIAL (SLM)
Demand Deposits: In most of the economically advanced countries like UK and USA the bulk of the total supply of money is deposit money which refers to the commercial banks’ total demand deposit. As such the course of behavior of the internal price level is greatly affected by changes in the volume of deposit money or bank credit. These demand deposits of the commercial banks are the outcome of the public deposits with the banks, and bank loans, advances and investments. The public deposits which are cash deposits are called ‘primary deposits’ because they are the result of the real savings of the people and deposits which are the result of banks’ loans and advances to customers are called ‘derivative deposits’ and represent the creation of credit by banks. The relative amounts of the two main sources of money supply, viz., the currency and demand deposits, depend upon the degree of monetization of the economy, banking habit, banking development, trade practices, etc. in the economy. For example, almost 80 per cent of the money supply of the US is made of demand deposits. While in underdeveloped countries like India, the proportion of the currency money to the total money supply with the public is considerably large because a very high percentage of transactions are performed through cash payments rather than credit instruments like cheques, etc. Sources of Money Supply: (i) Government (which Issues one-rupee notes and all other coins) (ii) RBI (which issues paper currency) (iii) Commercial banks (which create credit on the basis of demand deposits). Alternative measures of Money Supply (money stock): In India Reserve Bank of India uses four alternative measures of money supply called M1, M2, M3 and M4. Among these measures M1 is the most commonly used measure of money supply because its components are regarded most liquid assets. Each measure is briefly explained below. (i) M1 = C + DD + OD. Here C denotes currency (paper notes and coins) held by public, DD stands for demand deposits in banks and OD stands for other deposits in RBI. Demand deposits are deposits which can be withdrawn at any time by the account holders. Current account deposits are included in demand deposits. But savings account deposits are not included in DD because certain conditions are imposed on the amount of withdrawals and number of withdrawals. OD stands for other deposits with the RBI which includes demand deposits of public financial institutions, demand depositsof 77 CU IDOL SELF LEARNING MATERIAL (SLM)
foreign central banks and international financial institutions like IMF, World Bank, etc. (ii) M2 = M1 (detailed above) + saving deposits with Post Office Saving Banks (iii)M3= M1 + Net Time-deposits of Banks (iv)M4 = M3 + Total deposits with Post Office Saving Organization (excluding NSC) In fact, a great deal of debate is still going on as to what constitutes money supply. Savings deposits of post offices are not a part of money supply because they do not serve as medium of exchange due to lack of cheque facility. Similarly, fixed deposits in commercial banks are not counted as money. Therefore, M1 and M2 may be treated as measures of narrow money whereas M3 and M4 as measures of broad money. In practice, M1 is widely used as measure of money supply which is also called aggregate monetary resources of the society. All the above four measures represent different degrees of liquidity, with M4 being the most liquid and M4 is being the least liquid. It may be noted that liquidity means ability to convert an asset into money quickly and without loss of value. MONEY CREATION BY THE COMMERCIAL BANKING SYSTEM It is one of the most important activities of commercial banks. Through the process of money creation, commercial banks are able to create credit, which is in far excess of the initial deposits. This process can be better understood by making two assumptions: (i) The entire commercial banking system is one unit and is termed as ‘Banks’. (ii) All receipts and payments in the economy are routed through the Banks, i.e. all payments are made through cheques and all receipts are deposited in the banks. The deposits held by Banks are used for giving loans. However, banks cannot use the whole of deposit for lending. It is legally compulsory for the banks to keep a certain minimum fraction of their deposits as reserves. The fraction is called the Legal Reserve Ratio (LRR) and is fixed by the central bank. Banks do not keep 100% reserves against the deposits. They keep reserves only to the extent indicated by the Central Bank. Why only Fraction of deposits is kept as Cash Reserves? Banks keep a fraction of deposits as Cash Reserves because a prudent banker, by his experience, knows two things: 78 CU IDOL SELF LEARNING MATERIAL (SLM)
(i) All the depositors do not approach the banks for withdrawal of money at the same time and also they do not withdraw the entire amount in one go. (ii) There is a constant flow of new deposits into the banks. So, to meet the daily demand for withdrawal of cash, it is sufficient for banks to keep only a fraction of deposits as cash reserve. It means, if experience of the banks show that withdrawals are generally around 20% of the deposits, then it needs to keep only 20% of deposits as cash reserves (LRR). Let us now understand the process of Money Creation through an example: 1. Suppose, initial deposits in banks is Rs 1,000 and LRR is 20%. It means, banks are required to keep only Rs 200 as cash reserve and are free to lend Rs 800. Suppose they lend Rs 800. Banks do not lend this money by giving amount in cash. Rather, they open the accounts in the names of borrowers, who are free to withdraw the amount whenever the like. 2. Suppose borrowers withdraw the entire amount of X 800 for making payments. As all the transactions are routed through the banks, the money spent by the borrowers comes back into the banks in the form of deposit accounts of those who have received this payment. It will increase the demand deposits of banks by X 800. 3. With new deposits of X 800, banks keep 20% as cash reserves and lend the balance Rs 640. Borrowers use these loans for making payments, which again comes back into the accounts of those who have received the payments. This time, banks deposits rise by Rs 640. 4. The deposits keep on increasing in each round by 80% of the last round deposits. At the same time, cash reserves also go on increasing, each time by 80% of the last cash reserve. Deposit creation comes to end when total cash reserves become equal to the initial deposit. Money Multiplier: Money Multiplier or Deposit multiplier measures the amount of money that the Banks are able to create in the form of deposits with every unit of money it keeps as reserves. It is calculated as: Money Multiplier = 1/LRR It signifies that for every unit of money kept as reserves, banks are able to create 5 units of money. The value of money multiplier is determined by LRR. Higher the value of LRR, 79 CU IDOL SELF LEARNING MATERIAL (SLM)
lower is the value of money multiplier and less money is created by the banking system. CENTRAL BANK AND ITS FUNCTIONS It is very difficult to suggest a precise definition of a central bank. However, a central bank can best be defined with reference to its functions. It can be defined as the bank which stands as the leader of the money market—also called the financial market—issues notes and coins, supervises, controls and regulates the activities of the banking system and acts as the banker of the government. In our pyramidal financial structure, the central bank sits at the top. A central bank is a bank which constitutes the apex of the monetary and banking structure. It manages the economy in the interest of general public welfare, but not maximization of profit. According to W. A. Shaw, the central bank is the bank which controls credit. Samuelson defines central bank “…as a bank of bankers. Its duty is to control the monetary base and through control of this ‘high-powered money’ to control the community’s supply of money.” But as a private citizen, no one—even the Head of the country—either can open a bank account or borrow money from the central bank. Functions of Central Bank: One can find some differences in the style of functioning of a central bank. Its functions in an under•developed country differ from those in a developed country. But the central bank performs the following common but vital functions in every country. The most important ones are: (a) Monopoly Power of Note Issue: In the 19th century, commercial banks in many countries enjoyed the right to issue notes. As the notes issued by them lacked uniformity, governments could not be prevented from over-issuing (or under-issuing) of notes. In view of these problems, the central bank has been given the monopoly power of note issue. It has been empowered to do so in the interest of uniformity and to bring a balance between demand for money and supply of money (i.e., prevention of over-issue or under-issue of notes). The notes issued by the central bank are considered as legal tender money of the country and form the cash basis of the credit of commercial banks. Being the sole supplier of money in the economy, the central bank regulates the volume of currency of the country. It has also the power to withdraw worn and torn notes from circulation in exchange for new ones, so that 80 CU IDOL SELF LEARNING MATERIAL (SLM)
good quality notes and coins circulate in the economy. (b) Bankers’ Bank: Commercial banks are required, by law or convention, to keep a certain percentage of their deposits are serves with the central bank. In this way, it acts as a custodian of cash reserves. Banks draw cash balances from the central bank as and when the situation demands. As a bankers’ bank, it acts as a lender of the last resort. If commercial banks face serious liquidity crisis they approach the central bank and it stretches its lending hand to them— either by discounting bills or buying securities from them. This sort of accommodation makes the central bank a lender of the last resort. This is essential to prevent bank failure. It gives advice to banks on good/sound banking practice. A central bank usually discusses government policy with them and reports back to the government. Thus, a central bank closely monitors the activity of commercial banks. (c) Banker, Agent and Adviser to the Government: The central bank acts as a banker, agent and adviser to any government. As a banker of the government, it has to maintain banking accounts of both central and state governments. It makes and receives payments on behalf of the government as it acts as the agent of the government. Truly speaking, government (central, state, and union territories) expenditure (say, on road building, hospital construction, etc.,) and revenue (say from income tax, excise duty, etc.,) pass through the central bank. In brief, it performs merchant banking functions for the government. It also provides short-term loans and advances (known as ways and means advances) to the government to enable the latter to tide over its financial difficulties. It also advises the government on necessary monetary and financial matters such as market borrowing, loan repayment, deficit financing, control of inflation. (d) Controller of Credit: The central bank of a country prescribes broad parameters of banking operations within which the country’s banking and finance system operates. In a modern credit-oriented economy, credit is an important component of money supply. Being profit-making institutions, commercial banks may adopt the policy of undue expansion or contraction of credit to suit their needs. This may lead to inflation or deflation. Neither of the two is desirable. To ensure price stability, credit supply is to be regulated. And, this task has been entrusted with the central 81 CU IDOL SELF LEARNING MATERIAL (SLM)
bank. The central bank, through its credit control policy, intends to curb the lending potential of commercial banks. Actually, it keeps the creation of credit within limits. It is accepted that this is its most important function. However, for controlling credit, it uses several official instruments like the bank rate, open market operations, and so on. (e) Custodian of Foreign Exchange Reserves: With the aim of facilitating foreign trade and payment and promoting orderly development and maintenance of foreign exchange market, a central bank acts as the manager of foreign exchange. The central bank acts as the sole custodian of gold and foreign currencies forthe purpose of issuing notes and for correcting an adverse balance of payments situation. In this connection, one may note that, by holding gold and foreign currencies, the central bank intends to stabilize foreign exchange rate. Like internal price stability, stability in foreign exchange rate is equally vital. A central bank aims at affecting the foreign exchange rate (i.e., the rate at which one currency is converted into another currency) by buying and selling foreign currencies in the foreign exchange market. In addition to these functions, the central bank: I. Acts as a clearing house for the settlement of accounts of commercial banks; II. Studies different aspects of economic problems, compiles data and informa•tionand publishes reports and periodi•cals, etc. (f) Promotional and Developmental Functions: In an underdeveloped economy, a central bank, in addition to the above noted traditional functions, acts as a potential development agency. It is not only a controller and regulator of credit but also a promoter. Its task in LDCs is: (i) To develop the money and capital markets (ii) To strengthen the banking structure (iii) To meet the genuine financial needs of agriculture and industry, and so on. It protects the interest of depositors and provides cost-effective banking services to the public. In brief, it corrects the defects and removes the inefficiencies of the country’s monetary- financial system. These activities are called promotional or non-traditional activities of a central bank of LDCs. Thus, the pattern of economic development in low- 82 CU IDOL SELF LEARNING MATERIAL (SLM)
income countries like India is largely determined by the central bank. To conclude, it is futile to single out the most important function of a central bank. In fact, all its functions are important from the point of view of developing countries. Further, as far as the objective of growth with stability is concerned, there is no hard and fast rule to delimit the functions of a central bank. Its role and functioning keep on changing with the passage of time. The preamble of the Reserve Bank of India (being the country’s central bank) describes the basic functions of the RBI as: “…to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.” STRUCTURE OF RBI The Reserve Bank of India (RBI) is India’s central bank, also known as the banker’s bank. The RBI controls monetary and other banking policies of the Indian government. The Reserve Bank of India (RBI) was established on April 1, 1935, in accordance with the Reserve Bank of India Act, 1934. The Reserve Bank is permanently situated in Mumbai since 1937. Establishment of Reserve Bank of India The Reserve Bank is fully owned and operated by the Government of India. The Preamble of the Reserve Bank of India describes the basic functions of the Reserve Bank as: • Regulating the issue of Banknotes • Securing monetary stability in India • Modernizing the monetary policy framework to meet economic challenges The Reserve Bank’s operations are governed by a central board of directors, RBI is on the whole operated with a 21-member central board of directors appointed by the Government of India in accordance with the Reserve Bank of India Act. The Central board of directors comprise of: • Official Directors – The governor who is appointed/nominated for a period of four years along with four Deputy Governors 83 CU IDOL SELF LEARNING MATERIAL (SLM)
• Non-Official Directors – Ten Directors from various fields and two government Official Organization Structure Fig. 5.2 Organization Structure Objectives The primary objectives of RBI are to supervise and undertake initiatives for the financial sector consisting of commercial banks, financial institutions and non-banking financial companies (NBFCs). Some key initiatives are: • Restructuring bank inspections • Fortifying the role of statutory auditors in the banking system • Legal Framework Major Functions of RBI A. Monetary Authority 84 CU IDOL SELF LEARNING MATERIAL (SLM)
• Formulating and implementing the national monetary policy. • Maintaining price stability across all sectors while also keeping the objective of growth. B. Regulatory and Supervisory • Set parameters for banks and financial operations within which banking and financial systems function. • Protect investor’s interest and provide economic and cost-effective banking to the public. C. Foreign Exchange Management • Overseas the Foreign Exchange Management Act, 1999. • Facilitate external trade and development of foreign exchange market in India. D. Currency Issuer • Issues, exchanges or destroys currency and not fit for circulation. • Provides the public adequately with currency notes and coins and in good quality. E. Developmental role • Promotes and performs promotional functions to support national banking and financial objectives. F. Related Functions • Provides banking solutions to the central and the state governments and also acts as their banker. • Chief Banker to all banks: maintains banking accounts of all scheduled banks. Electronic Payments The initiatives taken by the Reserve Bank in the domain of electronic payment systems are immense and vast. The types of electronic forms of payment by the RBI are as follows: • Electronic Clearing Service (ECS) – This enables customer bank accounts to be credited with a specified value and payment on a set date. This makes EMIs, or other monthly bills hassle free. • National Electronic Clearing Service (NECS) – This facilitates multiple advantages to beneficiary accounts with destination branches against a single debit of the account of 85 CU IDOL SELF LEARNING MATERIAL (SLM)
the sponsor bank. • Electronic Funds Transfer (EFT) – This retail funds transfer system was to enable an account holder of a bank to electronically transfer funds to another account holder with any other intermediate or participating bank. • National Electronic Funds Transfer (NEFT) – A secure system to facilitate real-time fund transfer between individuals/corporates. • Real Time Gross Settlement (RTGS) – A funds transfer function in which transfer of money takes place from one bank to another on a real-time basis without delaying or netting with any other transaction. • Clearing Corporation of India Limited (CCIL) – This system is for banks, financial institutions, non- banking financial companies and primary dealers, to serve as an industry service mechanism for clearing settlement of trades in money market, government securities and foreign exchange markets. • The RBI (Reserve Bank of India) has made changes to the Prepaid Payment Instruments (PPI) also known as e-wallets. These changes include KYC – known your customer compliance. KYC is the process of collecting user details by the service provider and verifying the same with the respective government bodies. CONTROL OF CREDIT AND ITS TOOL (MONETARY POLICY) Credit and Monetary policy is the macroeconomic policy laid down by the central bank. It involves management of money supply and interest rate and is the demand side economic policy used by the government of a country to achieve macroeconomic objectives like inflation, consumption, growth and liquidity. In India, monetary policy of the Reserve Bank of India is aimed at managing the quantity of money in order to meet the requirements of different sectors of the economy and to increase the pace of economic growth. The RBI implements the monetary policy through open market operations, bank rate policy, reserve system, credit control policy, moral persuasion and through many other instruments. Using any of these instruments will lead to changes in the interest rate, or the money supply in the economy. Monetary policy can be expansionary and contractionary in nature. Increasing money supply and reducing interest rates indicate an expansionary policy. The reverse of this is a contractionary monetary policy. For instance, liquidity is important for an economy to spur growth. To maintain liquidity, the RBI is dependent on the monetary policy. By purchasing bonds through open market operations, the RBI introduces money in the system and reduces the interest rate. 86 CU IDOL SELF LEARNING MATERIAL (SLM)
The main objectives of Monetary Policy are: • To maintain price stability. • To ensure adequate flow of credit to productive sectors so as to assist growth. • Arrangement of full employment. • Expansion of credit facility • Equality & Justice Stability in exchange rate. • Promotion of Fixed Deposit. • Equitable distribution of Credit. There are two types of instruments of the monetary policy a) Quantitative and b) Qualitative. Let us understand each of these instruments in detail, A. Quantitative: a. Cash Reserve Ratio (CRR): Commercial Banks are required to hold a certain proportion of their deposits in the form of cash with RBI. CRR is the minimum amount of cash that commercial banks have to keep with the RBI at any given point in time. RBI uses CRR either to drain excess liquidity from the economy or to release additional funds needed for the growth of the economy. For example, if the RBI reduces the CRR from 5% to 4%, it means that commercial banks will now have to keep a lesser proportion of their total deposits with the RBI making more money available for business. Similarly, if RBI decides to increase the CRR, the amount available with the banks goes down. Current CRR: 4%. b. Statutory Liquidity Ratio (SLR): SLR is the amount that commercial banks are required to maintain in the form of gold or government approved securities before providing credit to the customers. SLR is stated in terms of a percentage of total deposits available with a commercial bank and is determined and maintained by the RBI in order to control the expansion of bank credit. Current SLR: 19.5% c. Bank Rate: It is a rate at which RBI lend long term loan to commercial banks. Bank rate is a tool which RBI uses for maintaining money supply. Any revision in bank rate by RBI is a signal to banks to revise deposit rates as well as prime lending rate (PLR is the rate at which bank lend to the bank customers). Current Bank Rate: 6.25% 87 CU IDOL SELF LEARNING MATERIAL (SLM)
d. Repo Rate: The rate at which the RBI is willing to lend short-term loans to commercial banks is called Repo Rate. Whenever commercial banks have any shortage of funds they can borrow from the RBI, against securities. If the RBI increases the Repo Rate, it makes borrowing expensive for commercial banks and vice versa. As a tool to control inflation, RBI increases the Repo Rate, making it more expensive for the banks to borrow from the RBI with a view to restrict the availability of money. The RBI will do the exact opposite in a deflationary environment when it wants to encourage growth. Current Repo Rate: 6% e. Reverse Repo Rate: The rate at which the RBI is willing to borrow from the commercial banks is called reverse repo rate. If the RBI increases the reverse repo rate, it means that the RBI is willing to offer lucrative interest rate to commercial banks to park their money with the RBI. This results in a reduction in the amount of money available for the bank’s customers as banks prefer to park their money with the RBI as it involves higher safety. This naturally leads to a higher rate of interest which the banks will demand from their customers for lending money to them. Current Rate: 5.75% f. Marginal Standing Facility (MSF): MSF is a very short term borrowing scheme for scheduled commercial banks. Banks may borrow funds through MSF during severe cash shortage or acute shortage of liquidity. Banks often face liquidity shortfalls due to mismatch in their deposit and loan portfolios. These are usually very short term and banks can borrow from RBI for one day period by offering dated government securities. MSF had been introduced by RBI to reduce volatility in the overnight lending rates in the inter-bank market and to enable smooth monetary transmission in the financial system. Under MSF, banks can borrow funds overnight up to 1% (100 basis points) of their net demand and time liabilities (NDTL) i.e. 1% of the aggregate deposits and other liabilities of the banks. NDTL liabilities represent a bank’s deposits and borrowings from others. In a move to stem the continuing fall of rupee, the RBI raised the MSF rate to 300 basis points (i.e. 3%) above the repo rate in July 2013. Thus, both rate of borrowing and percent of borrowing allowed under MSF can be varied by RBI. Current MSF: 6.25% g. Base Rate: Base Rate is the interest rate below which Scheduled Commercial Banks (SCBs) will lend no loans to its customers—its means it is like prime lending rate (PLR) and the benchmark prime lending Rate (BPLR) of the past and is basically a floor rate of interest. Current Base Rate: 8.65% – 9.45% h. Marginal Cost of Funds Lending Rate (MCLR): From the financial year 2016-17 (i.e., from 1st April, 2016), banks in the country have shifted to a new methodology to 88 CU IDOL SELF LEARNING MATERIAL (SLM)
compute their lending rate. The new methodology—MCLR (Marginal Cost of funds- based Lending Rate)— which was articulated by the RBI in December 2015. The main features of the MCLR are as follows: i) It will be a tenor linked internal benchmark, to be reset on annual basis. ii) Actual lending rates will be fixed by adding a spread to the MCLR. iii) To be reviewed every month on a pre-announced date. iv) Existing borrowers will have the option to move to it. v) Banks will continue to review and publish ‘Base Rate’ as hitherto. Current rate: 7.65% – 8.05%. i. Call Money Market: The call money market is an important segment of the money market where borrowing and lending of funds take place on overnight basis. Participants in the call money market in India currently include scheduled commercial banks (SCBs)—excluding regional rural banks), cooperative banks (other than land development banks), insurance. Prudential limits, in respect of both outstanding borrowing and lending transactions in the call money market for each of these entities, are specified by the RBI. Current Rate: 4.90 % – 6.10% j. Open Market Operations (OMOs): OMOs are conducted by the RBI via the sale/purchase of government securities (G-Sec) to/from the market with the primary aim of modulating rupee liquidity conditions in the market. OMOs are an effective quantitative policy tool in the armory of the RBI, but are constrained by the stock of government securities available with it at a point in time. Other than the institutions, now individuals will also be able to participate in this market (as per the Union Budget 2016–17). k. Liquidity Adjustment Framework (LAF): The LAF is the key element in the monetary policy operating framework of the RBI (introduced in June 2000). On daily basis, the RBI stands ready to lend to or borrow money from the banking system, as per the need of the time, at fixed interest rates (repo and reverse repo rates). Together with moderating the fund mismatches of the banks, LAF operations help the RBI to effectively transmit interest rate signals to the market. The recent changes regarding a cap on the repo borrowing and provision of the term repo have changed the very dynamics of this facility after 2013. l. Market Stabilization Scheme (MSS): This instrument for monetary management was introduced in 2004. Surplus liquidity of a more enduring nature arising from 89 CU IDOL SELF LEARNING MATERIAL (SLM)
large capital inflows is absorbed through sale of short-dated government securities and treasury bills. The mobilized cash is held in a separate government account with the Reserve Bank. The instrument thus has features of both, SLR and CRR. B. Qualitative: a. Fixing Margin Requirements: The margin refers to the “proportion of the loan amount which is not financed by the bank”. Or in other words, it is that part of a loan which a borrower has to raise in order to get finance for his purpose. A change in a margin implies a change in the loan size. This method is used to encourage credit supply for the needy sector and discourage it for other non-necessary sectors. This can be done by increasing margin for the non-necessary sectors and by reducing it for other needy sectors. Example: - If the RBI feels that more credit supply should be allocated to agriculture sector, then it will reduce the margin and even 85-90 percent loan can be given. b. Consumer Credit Regulation: Under this method, consumer credit supply is regulated through hire-purchase and installment sale of consumer goods. Under this method the down payment, installment amount, loan duration, etc is fixed in advance. This can help in checking the credit use and then inflation in a country. c. Publicity: This is yet another method of selective credit control. Through it Central Bank (RBI) publishes various reports stating what is good and what is bad in the system. This published information can help commercial banks to direct credit supply in the desired sectors. Through its weekly and monthly bulletins, the information is made public and banks can use it for attaining goals of monetary policy. d. Credit Rationing: Central Bank fixes credit amount to be granted. Credit is rationed by limiting the amount available for each commercial bank. This method controls even bill rediscounting. For certain purpose, upper limit of credit can be fixed and banks are told to stick to this limit. This can help in lowering banks credit exposure to unwanted sectors. e. Moral Suasion: It implies to pressure exerted by the RBI on the Indian banking system without any strict action for compliance of the rules. It is a suggestion to banks. It helps in restraining credit during inflationary periods. Commercial banks are informed about the expectations of the central bank through a monetary policy. Under moral suasion central banks can issue directives, guidelines and suggestions for commercial banks regarding reducing credit supply for speculative purposes. f. Control through Directives: Under this method the central bank issue frequent 90 CU IDOL SELF LEARNING MATERIAL (SLM)
directives to commercial banks. These directives guide commercial banks in framing their lending policy. Through a directive the central bank can influence credit structures, supply of credit to certain limit for a specific purpose. The RBI issues directives to commercial banks for not lending loans to speculative sector such as securities, etc beyond a certain limit. g. Direct Action: Under this method the RBI can impose an action against a bank. If certain banks are not adhering to the RBI’s directives, the RBI may refuse to rediscount their bills and securities. Secondly, RBI may refuse credit supply to those banks whose borrowings are in excess to their capital. Central bank can penalize a bank by changing some rates. At last it can even put a ban on a particular bank if it does not follow its directives and work against the objectives of the monetary policy. These are various selective instruments of the monetary policy. However the success of these tools is limited by the availability of alternative sources of credit in economy, working of the Non-Banking Financial Institutions (NBFIs), profit motive of commercial banks and undemocratic nature off these tools. But a right mix of both quantitative and qualitative tools of monetary policy can give the desired results. SUMMARY • In a nutshell, money is a sort of public-private partnership in which the risks have gravitated towards the public sector while the benefits have gravitated towards the private sector. Money and credit creation should in fact be recognized as a common good managed for the benefit of society as a whole — not just for the benefit of the private banking sector. • The money and banking system has become very complex in the last thirty years with the financialization of banking, the emergence of shadow banking and the globalization of the wholesale money market. Getting a grasp of it can feel overwhelming. Yet, the key design features of the system can be easily understood. They reveal the role the system plays in the problems we face and a strategy to redesign it so that money works for the collective benefit and within the limits imposed by finite ecosystems. It is essential for our democracy that the general public understands these matters and feels empowered to challenge and reshape the money and banking system. • Money is created when the government prints it, right? That’s only partially true because banks create money too. Banks don’t literally print their own currency (save for a few banks in Scotland, who do just that). So how does a bank “create” money? 91 CU IDOL SELF LEARNING MATERIAL (SLM)
• Recall that the narrowest definition of the money supply is M1, which includes money in circulation (not held in a bank) and demand deposits held inside banks. In the United States, less than half of M1 is in the form of currency—much of the rest of M1 is in the form of bank accounts. • Every time a dollar is deposited into a bank account, a bank’s total reserves increases. The bank will keep some of it on hand as required reserves, but it will loan the excess reserves out. When that loan is made, it increases the money supply. • This is how banks “create” money and increase the money supply. When a bank makes loans out of excess reserves, the money supply increases. We can predict the maximum change in the money supply with the money multiplier. KEY WORDS/ABBREVIATIONS • Capital - Assets which are available for a purpose such as investment or starting a company. It is different to money because money is used only to purchase things, capital is used to generate wealth, e.g. through investment. • Capital market - The financial system which raises capital by dealing in shares, bonds and long term investments. • Cash flow - The amount of money being transferred in and out of a business, affecting liquidity. • Financial Instrument - A document involving monetary value which can be equity based, represent ownership of an asset or represent a loan made to an owner of an asset. They are tradeable packages of capital. Essentially, it is an equity, asset or loan. • Liability - A company's debts that arise during its business operations, e.g. loans. LEARNING ACTIVITY 1. Note on High Powered Money 2. Explain organization structure of RBI 92 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT END EXERCISES (MCQS AND DESCRIPTIVE) A. Descriptive Questions 1. Note on Quantitative Techniques of Credit Control 2. Note on RBI 3. Explain the term money supply 4. What is a central bank? State its functions 5. Note on Control of Credit & its tools by Central Bank B. Multiple Choice Questions (MCQs) 1. The volume of paper currency is controlled by the (a) Monetary authority (b) Government (c) Foreign agencies (d) None to these 2. Which of the following is issued by RBI? (a) Currency (b) Coins (c) Both (d)None of these 3. Which of the following about money supply measure adopted in 1977 is correct? (a) M2= M1 +demand deposits with post offices (b) M3= M1 +term deposits with banks (c) M4=M3+total deposits with post offices (d) All of these 93 CU IDOL SELF LEARNING MATERIAL (SLM)
4. Which of the following is known as broad money? (a) M1 (b) M2 (c) M3 (d) M4 5. Which one out of the following is most liquid among the measures of money supply? (a) M1 (b) M2 (c) M3 (d) M4 Answers: 1. (a) 2. (a) 3. (d) 4. (d) 5. (a) REFERENCES • Dwivedi, D.N. (2006). Macroeconomics: Theory and Policy. New Delhi: Tata McGraw Hill. • Ray, N.C. (1980). An introduction to Macro Economics. New Delhi: The Macmillan Company of India. • Lipsey, R.G. & Chrystal, K.A. (2004). Economics. New Delhi: Oxford University Press. • Shapiro, Edward. (2009). Macroeconomic Analysis. New York: Harcourt Publishers Ltd. • Peterson, L., Jain. (2005). Managerial Economic. New Delhi: Prentice Hall of India. • Mote, V.L., Gupta G.S. (2017). Managerial Economics. New Delhi: McGraw Hill Education. 94 CU IDOL SELF LEARNING MATERIAL (SLM)
95 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT 6- COMPONENTS OF AGGREGATE DEMAND (AD) Structure Learning Objectives Introduction Open and closed economy A closed economy does not enter into any one of the activities An open economy involves itself in the following activities Psychological law of consumption, MPC & APC MPS & APS APS MPS Relationship between APS & MPS Relationship between MPC & MPS Summary Key Words/Abbreviations Learning Activity Unit End Exercises (MCQs and Descriptive) References LEARNING OBJECTIVES After studying this unit, you will be able to: • Describe the Psychological law of consumption • Give details of the terms MPC & APC • Explain the terms MPS & APS INTRODUCTION 96 CU IDOL SELF LEARNING MATERIAL (SLM)
Aggregate Demand is the total demand in the economy. AD = C + I + G + (X-M) C= Consumer spending (Household consumption) I = Investment (gross fixed capital formation) G= Government spending (Government investment and Government consumption) X-M = Net Exports (exports – imports). Aggregate Demand curve Fig. 6.1 Aggregate Demand curve AD slopes downwards because: • At a lower price level, people are able to consume more goods and services, because their real income is higher. • At a lower price level, interest rates usually fall causing increased spending. • At a lower price level, exports are relatively more competitive than imports. OPEN AND CLOSED ECONOMY A closed economy does not enter into any one of the following activities - (i) It neither exports goods and services to the foreign countries nor imports goods and services 97 CU IDOL SELF LEARNING MATERIAL (SLM)
from the foreign countries. (ii) It neither buys shares, debentures, bonds etc. from foreign countries nor sells shares, debentures, bonds etc. to foreign countries, thus it is financially also as closedeconomy. (iii) It neither borrows from the foreign countries nor lends to the foreign countries. (iv) It neither receives gifts from foreigners nor sends gifts to foreigners. (v) Normal residents of a closed economy cannot go to other countries to work in their domestic territory. No foreigner is allowed to work in the domestic territory of a closed economy. Situation where no external trade occurs is also called autarky. Due to above mentioned reasons; Gross Domestic Product and Gross National Product are the same in a closed economy. However, in strict sense, absolutely closed economies are non-existent today as every country trades with the rest of the world. However a closed economy term is used for the economies with high tariff walls, having relatively low level of foreign trade. India before globalization was considered as a closed economy because it was very apprehensive towards foreign trade and protected its domestic boundaries through high tariff walls. Foreign investment was also not promoted due to the bitter experience of East India Company of England. On the other hand, an open economy is one, which is not only involved in the process of production within its domestic territory but also can participate in production anywhere in the rest of the world An open economy involves itself in the following activities. (i) It buys shares, debentures, bonds etc. from foreign countries and sells shares, debentures, bonds etc. to foreign countries. (ii) It borrows from foreign countries and lends to foreign countries. (iii) It can send gifts and remittances to foreigners and can receive the same from them. (iv) Normal residents of an open economy can move or be employed and are allowed to work in the domestic territory of other economies. (v) Due to these reasons, Gross Domestic Product and Gross National Product are not same in an open economy. It is to be noted that at present all economies of the world are open economies. Most economies in their initial stages of development follow relatively closed economy policy as their fear that the competition from MNCs may crush their nascent domestic industries. Such policies were followed by India, USA etc in their initials stages of 98 CU IDOL SELF LEARNING MATERIAL (SLM)
development. Thus the self-reliance was a major objective behind the closed economic policies. Once their domestic industries developed to take the might of MNCs, they adopted the open economic policies. Many economists held that domestic industries must be protected in the initial stages of development but once the domestic industries gathered strength, country must adopt the open economic policy. According to them nurse the baby, rear the child and free the adult i.e. with the gradual development, industries must be freed to take on the world competition. In case of agriculture, India still follows the closed economy policy as Indian farmers are still vulnerable to the highly subsidized Agri-products of developed world. Another argument which favors the closed economy is the insulation of domestic economy from the cyclical upswings of the world economy. More a country attached to the foreign trade and investment, more it is vulnerable to the global slowdown. If India didn’t have foreign trade and investment with USA, it would not have been impacted by the financial crisis of 2008-09. In 1930s, due to the relative insulation of Russian economy from the other capitalists’ economies of the world, it wasn’t impacted by the Great Depression of 1930s. In this manner autarky also provides a shield from the global upheavals However, the benefits of open economy quite outnumber the advantages of closed economy. An open economy widens the market of a country to such an extent which a closed economy can never realize. If Indian and Japanese, both are a trillion dollar market, by entering into a free trade pact, both countries widened their market to the tune of 2 trillion dollar, thus bringing upon the huge prospects for their companies in an enlarged market. Benefits of an open economy can be surmised by comparing India’s economic performance in the pre and post globalization years. In the pre globalization era, the globalization years, GDP growth rate of India was sarcastically called as Hindu Growth rate while in the post globalization years, Indian economy has emerged as one of the fastest growing economy of the world. Moreover, in an open economy, prices are also found to be low and the qualities of products are better due to increased competition. Consumers also have more choices for consumption. When India was a closed economy, if you have to buy a car, there were only three choices, Maruti, Fiat and Ambassador, while now; there is a vast array of companies. Another benefit of an open economy is that it is more flexible. An open economy has a greater chance of adjusting itself with the changes taking place in world economy. Though it is true that an open economy is vulnerable to the global risks like slowdown but it 99 CU IDOL SELF LEARNING MATERIAL (SLM)
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