Unit-2 Money
Unit-2 Money
MONEY
Learning Objectives
2
Introduction
In the beginning of human civilization, people had very few wants. They could
meet their needs themselves. As such, there was no need of money. With the
development of civilization, human wants multiplied rapidly. So they could not
meet their needs which led to interdependence between them. Hence, the
barter system came into existence to fulfil the initial needs of exchange.
But a number of difficulties were observed in this system. A need was felt that
there should be such a system that could save all from these difficulties. Money
came into existence in these circumstances.
According to D.H. Robertson,“Anything which is widely accepted in payment
for goods or in discharge of other kinds of business obligations is called money.”
According to Crowther, money is “Anything that is generally acceptable as a
means of exchange (i.e., as a means of setting debts) and, at the same time,
acts as a measure and as a store of value.”
Barter System
Before the introduction of money, goods and services were exchanged for
goods and services. This practice is known as barter system. It is the exchange
system without the use of money. The economy with barter system is known
as barter economy. Barter system became rare in practice because it had
following difficulties:
1. Lack of double coincidence of wants
2. Lack of common measure of value
3. Lack of divisibility
4. Lack of store of value
5. Difficult to use as a deferred payment
6. Difficulty in Transfer of value
Characteristics of Good Money
2. Divisibility:
Money must be 3. General 4. Stability in
5. Scarcity:
divisible into Acceptability: Value: Money
1. Portability: Money must be
smaller Money must be must have a
Money must be limited in supply
denomination to generally stable value in
portable. It to have a
facilitate small acceptable. It terms of the
should be light reasonable
transactions. avoids things it can buy.
in weight to be value. Moreover,
Paper money inconvenience If the value of
easily carried there should not
and coins do this and facilitates money changes
out. This be undue
job very well. For easy and wide by large
characteristic increase in the
instance, paper circulation of magnitude,
makes paper supply of money
notes of Rs.1, 2, money. It also money may fail
money as the so that its value
5, 10 and 20 reduces chances to perform its
ideal money. is maintained
enable us to of counterfeit functions
relatively stable.
make small money. properly.
purchases.
Importance of Money
Money is one of the greatest invention of mankind. It is the guiding star of all economic activities in the
modern economy. It plays a dominant role in all the fields of economics viz., consumption, production,
exchange, distribution and public finance.
Alfred Marshall rightly says that, “Money is the pivot around which economic science clusters.” The
following are the roles of money in the modern economy:
1.Consumption: In the field of consumption, money measures the marginal utility obtained from the
consumption of a commodity. It helps the consumer to equalize the marginal utility derived from different
commodities and to maximize his satisfaction.
2.Production: Before the advent of money, producers were always hesitant to produce more. They used to
produce only that much which could be bartered in the local market. But the introduction of money assured
the producers or entrepreneurs about the sale of their product; as such, the volume and variety of
production went on increasing.
3.Exchange: Money has removed all the difficulties of barter system. Money serves as medium of exchange
and measure of value. It has general purchasing power. Anything can be bought directly with the help of
money.
4.Distribution: Production is the result of joint efforts of different factors of production. These factors of
productions are land, labour, capital and organization. Money enables the producer to distribute the shares
of the factors of production in the form of rent, wage, interest and profit.
5.Public Finance: Public finance means funding function of the state. The government collects taxes, fees,
penalty, interest and prices, etc. in terms of money. The money so collected is utilized for administrative and
developmental purposes. Without money, the functions of a modern state would become almost impossible.
Functions of Money
The functions of money can be explained under the following three headings:
1. Primary Functions: The primary functions of Money are two fold:
i. Medium of Exchange ii. Measure of Value
According to Keynes, "Inflation is the result of the excess of aggregate demand over the
available aggregate supply and true inflation starts only after full employment".
Inflation is the rise in general price level. But every rise in general price level is not
inflation. It is the persistent and appreciable rise in general price level. Inflation causes the
decrease in value of money or the purchasing power of money. Hence, the cost of l
Features of Inflation: The following are the main features of inflation:
1. Inflation is the rise in general price level, not a state of high price.
2. Inflation is not a small or temporary fluctuation but is a sustained and appreciable
rise in general price level.
3. Inflation is not the increase in relative/individual prices but is the increase in general
price level.
4. Pure inflation starts after full employment.
5. Inflation may be demand-pull or cost-push.
Demand-pull Inflation
AS
For explanation, juts go
through the book in details.
Price Level
P2 E2
P1 E1 AD2
P E AD1
AD
O X
YF
Aggregate Demand and Aggregate Supply
Causes of Demand-pull Inflation
1. Increase in Money Supply and Bank Credit: Due to the increase in money supply and
bank credit, investment, income and consumption also increases.
2. Decrease in Interest Rate: Decrease in interest rates causes a rise in consumer spending
and higher investment. This will lead a rise in aggregate demand and inflationary pressures.
3. Increase in Government Expenditure: When there is increase in government
expenditures in the form of regular and development expenditure, there will be directly increase in
demand for goods and services.
4. Decrease in Tax Rate: The low rate of taxes increases disposable income and hence the
purchasing power of people which makes the aggregate demand high. This leads to demand-pull
inflation.
5. Increase in Export: Due to increase in export, there will be increase in aggregate demand.
If supply of goods cannot be increased accordingly then demand-pull inflation arises.
6. Currency Devaluation: The main aim to devaluate a currency is to increase exports
relative to import. Increase in exports leads to increase in the demand for domestic goods relative
to its supply. This causes the price level to rise.
Cost-push Inflation
Inflation resulting from the decrease in aggregate supply due to the
increase in cost of production is called cost-push inflation. When there is
rise in prices of factors of production there will be increase in cost of
production. This will lead to a decrease in aggregate supply and hence
the rise in price level called cost-push inflation.
In the figure 9.3, aggregate demand and aggregate Y
supply are measured along the X-axis and price level
along the Y-axis. AD is the aggregate demand curve
Price
and AS is the aggregate supply curve. The AS curve is Level
upward sloping in the beginning and becomes parallel P2
P1
to the Y-axis when full employment is reached. AD and E
P
AS curves intersect with each other at point E where AS2
AS1 AD
general price level is OP. When prices of factors
AS
production rises, the cost of production increases and
the AS curve shifts to AS1 resulting price level to rise O
M N YF
X
from OP to OP1. Further shift in AS to AS2, the price Aggregate Demand and Aggregate Supply
1. Increase in Wage: Existence of strong trade union exercises its union power to
increase the real wage rate of the labour. The cost-push inflation originating from the increased
wage rage is called wage-push inflation.
2. Increase in Profit Margin: When the producers increase their profit margin, price will
definitely rise. The inflation originating from the increased profit-margin is called profit-push
inflation.
3. International Reason: The economy of a country is linked with other countries. If the
price of consumer goods raw materials and capital goods increase in foreign countries the price
of goods and services also increases in the country.
5. War: When there is war between the countries or within a country then the productive
resources of a country are diverted towards the production of arms and ammunitions. This
causes the production of necessary goods to fall. Hence the supply decreases and price level
rises.
Consequences of Inflation
b. Effects on Distribution: During inflation, the fixed income groups like pensioners, interest and
rent earners, etc. are always the losers. Similarly, salaried persons like factory workers, teachers, etc.
are also the losers because incomes do not increase as faster as the prices. Inflation is unjust
because it puts the economic burden on those sections of the society who are least able to bear it.
c. Effects on Society: High rate of inflation leads to social unrest situation in the economy.
Dissatisfaction increases among the workers. They demand higher wages to sustain their present
living standard. Moreover, high rate of inflation leads to a general feeling of discomfort for the
household as their purchasing power is consistently falling.
d. Effects on Moral: Inflation adversely affects business morality and ethics. It encourages black
marketing and enables the businessmen to reap wind-fall gains by undesirable men in order to
increase the profit margin, the producers reduce the quality by introduction of adulteration in their
products.
e. Effects on Politics: Inflation also disrupts the political life of a country. It corrupts the politicians
and weakens the political discipline. The increase in inequality and moral degradation from the
inflation can also lead to the loss of faith in the government. Rising prices also encourage agitations
and protests by political parties opposed to the government. This may lead to frequent change in
government.
Deflation
Deflation is a sustained decrease in the general price level in an
economy. It is the situation of falling general price level or rising value
of money. According to Crowther, "Deflation is the state of economy
where the value of money is rising or prices are falling."
Deflation is associated with fall in prices, but each and every fall in
price is not a deflation. Only those falls in price which results in
unemployment, overproduction and fall in the economic activity are
deflationary. Thus deflation is a situation where prices are falling with
the fall in income, output and employment.
Causes of Deflation:
a. Reduction in money supply b. Increase in rate of interest
c. Increase in tax rate d. Increase in production
e. Other policies of credit control
Consequences of Deflation
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