- In November 2016, ₹500 and ₹1000 notes were demonetised.
- Aim: curb black money, corruption, fake currency, terrorism.
- Caused short-term cash crunch and disruption.
- Led to better tax compliance and more money in banks.
- Encouraged digital and formal transactions.
Definitions [1]
Definitions: Money
- Prof. Crowther: "Money is anything that is generally acceptable as a means of exchange and at the same time acts as a measure and store of value."
- Prof. Walker: "Money is what money does" (Shows money is defined by its functions).
- Robertson: "Anything widely accepted in payment for goods" (Focuses on exchange function).
- “Anything which is commonly used and generally accepted as a medium of exchange or as a standard of value.” — Dr. Kent
Formulae [6]
Transaction demand for money
\[M_d^T=kT\]
where \[M_d^T\] = transaction demand for money,
T = total value of nominal transactions in the period,
k = positive fraction of transaction value held as money.
Velocity form of the same identity
\[\frac{1}{k}M_d^T=T\quad\Rightarrow\quad vM_d^T=T\]
where \[v=\frac{1}{k}\] is the velocity of circulation of money (number of times each unit of money changes hands in the period).
Transaction demand as a function of nominal GDP
\[M_d^T=kPY\]
where Y = real GDP and P = general price level (GDP deflator), so PY = nominal GDP.
Speculative demand for money
\[M_d^S=\frac{r_\max-r}{r-r_\min}\]
where
\[M_d^S\] = speculative demand for money,
r = current market rate of interest,
rmax = upper limit of r,
rmin = lower limit of r.
As r falls towards rmin, \[M_d^S\]→∞ (liquidity trap).
Transaction demand
\[M_d^T=kPY\]
where k>0, PP = price level, Y = real GDP.
Aggregate demand for money
\[M_d=M_d^T+M_d^S\quad\Rightarrow\quad M_d=kPY+\frac{r_\max-r}{r-r_\min}\]
Key Points
Key Points: Concept of Money
- Money eliminates barter system problems by providing a common medium of exchange.
- Three main functions: medium of exchange, measure of value, store of value.
- Must be generally acceptable to function as money.
- Modern economy completely depends on money for smooth transactions.
- Digital payments are the newest evolution in money's history.
Key Points: Functions of Money
- Medium of Exchange & Measure of Value: Money is used to buy and sell goods and services and to express prices, income, and expenditure in a common unit.
- Standard of Deferred Payments & Store of Value: Money makes future payments (loans, wages) easy and allows saving for future needs.
- Transfer of Value & Liquidity: Money helps transfer value across persons and places and is the most liquid form of wealth.
- Basis of Credit & Economic Measurement: Money forms the base of bank credit and helps measure national income and other macroeconomic variables.
Key Points: Demand for Money and Supply of Money
- Demand for money depends on income (transactions) and rate of interest.
- Higher income → higher demand for money; higher interest rate → lower demand for money.
- Money supply consists of cash and bank deposits.
- Central Bank (RBI) issues currency and controls money supply (high-powered money).
- Commercial banks create money through deposit and credit creation.
Key Points: Money Creation by Banking System
- Banks create money by lending, as all depositors do not withdraw money at the same time.
- When a bank gives a loan, it creates a new deposit, increasing money supply.
- Assets of a bank = Reserves + Loans.
- Liabilities of a bank = Deposits.
- Money supply (M1) = Currency + Deposits; with no currency, M1 equals total deposits.
Key Points: Limits to Credit Creation and Money Multiplier
- Banks cannot create unlimited credit due to reserve requirements set by RBI.
- Cash Reserve Ratio (CRR) is the minimum percentage of deposits banks must keep as cash reserves.
- Higher CRR → lower credit creation; lower CRR → higher credit creation.
- Money Multiplier = 1 / CRR, shows how much total deposits can be created.
- With CRR = 20%, ₹100 reserves can create ₹500 deposits (multiplier = 5).
Key Points: Policy Tools To Control Money Supply
- RBI controls money supply and acts as the lender of last resort to banks.
- Quantitative tools: CRR, Bank Rate, Open Market Operations (OMO).
- Higher CRR or Bank Rate reduces lending and decreases money supply.
- Open Market Operations: RBI buys bonds → money supply increases; sells bonds → money supply decreases.
- Repo and Reverse Repo rates are key modern tools of RBI’s monetary policy.
Key Points: Various Measures of Supply of Money
- Money includes currency notes, coins, and demand deposits (savings & current accounts).
- Currency notes are issued by RBI and coins by the Government of India.
- Demand deposits are payable on demand and used for transactions; time deposits are not money.
- Currency has value due to government/RBI guarantee, not intrinsic value (fiat money).
- Currency is legal tender, but cheques are not legal tender.
Key Points: Demonetisation
Important Questions [4]
- Explain the ‘Unit of Accounts’ Function of Money. How Has It Solved the Related Problem Created by Barter?
- Explain the Significance of 'Medium of Exchange' Function of Money
- Explain the 'Medium of Exchange' Function of Money. How Has It Solved the Related Problem Created by Barter?
- ‘Money is an asset which can be stored for use in future. In the light of given statement, identify the function of money.
Concepts [12]
- Concept of Money
- Functions of Money
- Demand for Money and Supply of Money
- Money Creation by Banking System
- Limits to Credit Creation and Money Multiplier
- Policy Tools To Control Money Supply
- Demand and Supply for Money : A Detailed Discussion
- The Transaction Motive
- The Speculative Motive
- Various Measures of Supply of Money
- Legal Definitions: Narrow and Broad Money
- Demonetisation
