Ch-3 Concept Of Money Demand Flashcards
Q1) what is the functions of money ? Or money has four functions: A medium, a measure, a standard and a store. Elucidate?
✴️ money is a convenient medium of exchange:
🔷it is an instrument that facilitates easy exchange of goods and services.
🔷Money commands purchasing power and its possession enables us to purchase goods and services to satisfy our wants.
🔷By acting as an intermediary , money increases the ease of trade and reduces the inefficiency and transaction costs involved in a barter exchange.
🔷By decomposing the single barter transaction into two separate transactions of sale and purchase, money eliminates the need for double coincidence of wants.
🔷Money also facilitates separation of transactions both in time and place and this in turn enables us to economize on time and effort involved in transactions.
✴️ Money is explicitly define as unit of value: / explain the function of money as a unit of account.
🔷money is a common measure of value’ or ‘common denominator of value or money functions as a numeraire. Rupee is the unit of account in India in which the entire money is denominated.
🔷The value of each good or service is expressed as price, which is nothing but the number of monetary units for which the good or service can be exchanged.
🔷 it is convenient to measure the prices of all commodities in terms of a single unit, rather than record the relative price of every good in terms of every other good.
🔷 An obvious advantage of having a single unit of account is that it greatly reduces the number of exchange ratios between goods and services.
🔷Use of money as a unit of account can encourage trade by making it easier for individuals to know how much one good is worth in terms of another.
🔷A common unit of account facilitates a system of orderly pricing which is crucial for rational economic choices.
🔷Goods and services which are otherwise not comparable are made comparable through expressing the worth of each in terms of money.
🔷The value of money is linked to its purchasing power. Purchasing power is the inverse of the average or general level of prices .
✴️ Money serves as a unit or standard of deferred payment:
🔷money facilitates recording of deferred promises to pay.
🔷 Money is the unit in terms of which future payments are contracted or stated.
🔷 However, variations in the purchasing power of money due to inflation or deflation, reduce the efficacy of money in this function.
✴️ Money is a store of value or do you think money is a unique store of value:
🔷People prefer to hold it as an asset, that is, as part of their stock of wealth.
🔷The splitting of purchases and sale into two transactions involves a separation in both time and space. This separation is possible because money can be used as a store of value or store of means of payment during the intervening time.
🔷Again, rather than spending one’s money at present, one can store it for use at some future time.
🔷Money also functions as a permanent store of value :
🔷There are many other assets such as government bonds, deposits and other securities, land, houses etc. which also store value. Despite having the advantages of potential income yield and appreciation in value over time, these other assets are subject to limitations such as storage costs, lack of liquidity and possibility of depreciation in value. Money is the only asset which has perfect liquidity.
🔷Additionally, money also commands reversibility as its value in payment equals its value in receipt. All assets other than money lack perfect reversibility in the sense that their value in payment is not equal to their value in receipt. Even financial assets like the riskless government bonds do not command perfect reversibility as their purchase and sale are subject to certain brokerage costs although this may be quite small.
🔷in order to serve as a permanent store of value in the economy, the purchasing power or the value of money should either remain stable or should monotonically rise over time.
Q2) what are some general characteristics that money should possess?
There are some general characteristics that money should possess in order to make it serve its functions as money. Money should be:
🔷generally acceptable
🔷durable or long-lasting
🔷effortlessly recognizable.
🔷difficult to counterfeit i.e. not easily reproducible by people
🔷relatively scarce, but has elasticity of supply
🔷portable or easily transported
🔷 possessing uniformity, and
🔷divisible into smaller parts in usable quantities or fractions without losing value
Q3) what are some of the important variables on which demand for money depends on? Or how much money people would like to hold in liquid form depends on many factors. What are they?
1) INCOME : higher the income of individuals, higher the expenditure and Richer people hold more money to finance their expenditure.
2) GENERAL LEVEL OF PRICES (INFLATION) : the quantity is directly proportional to the prevailing price level ; higher the prices, higher should be the holding of money.
3) RATE OF INTEREST:one May hold is wealth in any form other than money, se as an interest yielding asset . It follows that the opportunity cost of holding money is the interest rate a person could earn on other assets. Therefore, higher the interest rate, higher would be the opportunity cost of holding cash and lower the demand for money.
4) REAL GDP : an increase in GDP will raise the demand for money.
5) DEGREE OF FINANCIAL INNOVATION : innovations such as internet banking, application based transfers and automatic teller machines reduce the need for holding liquid money.
Q4) write a short note on classical approach : the quantity theory of money ( QTM) ? Or explain the classical version of quantity theory of demand for money? Or explain the following modified equation of exchange As given by Irving fisher : MV + M’V’ = PT
🔷 the quantity theory of money, one of the oldest theory in economics, was first propounded by Irving fisher of yale University in his book ‘ the purchasing power of money’ published in 1911 and later by the neo-classical economists .
🔷 QTM demonstrate that there is strong relationship between money and price level.
🔷the general price level of goods and services is directly proportional to the amount of money in circulation or money supply.
🔷 Fisher’s version, also termed as ‘equation of exchange’ aur ‘transaction approach’ is formally stated as follows : MV=PT
Where,
M= the total amount of money in circulation (on an average) in an economy.
V = transactions velocity of circulation i.e. the average number of times across all transactions a unit of money(say Rupee) is spent in purchasing goods and services.
P = average price level (P= MV/T)
T = the total number of transactions.
🔷Later, Fisher extended the equation of exchange to include demand (bank) deposits (M) and their velocity (V’) in the total supply of money. Thus, the expanded form of the equation of exchange becomes:
MV + M’V’ = PT
Where
M’ = the total quantity of credit money
V’ = velocity of circulation of credit money
🔷 The equation can also be written as P=(MV+M’V’)/T
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