Monetary Economics: One Mark Questions, Book Back Answers and Notes

About Monetary Economics

Medium ~90 min study

"Money is what money does." Francis A. Walker's line is a good starting point, because money is best understood through its functions. Before money, people used barter, which works only when each person wants exactly what the other has. Money removed that problem and made trade, saving and borrowing much easier.

The unit then moves from money itself to the quantity of money in the economy. The Reserve Bank of India measures money supply at four levels, \(M_1\) to \(M_4\). The quantity theories explain what happens to prices when that quantity changes, which leads naturally to inflation, deflation and stagflation, and finally to trade cycles, the ups and downs of economic activity in a capitalist economy.

Before the exam, make sure you can classify a function of money as primary, secondary or contingent, say which measure of money supply includes post office deposits, explain each symbol in \(MV = PT\), match a type of inflation with its cause and put the phases of a trade cycle in order. Also be clear on how Fisher's approach differs from the Cambridge approach: one looks at money spent, the other at money held.

What you'll learn

• Describe the evolution of money from barter to plastic and digital money.
• Classify the functions of money as primary, secondary or contingent.
• Define \(M_1\), \(M_2\), \(M_3\) and \(M_4\) and separate narrow money from broad money.
• Compare Fisher's transactions approach with the Cambridge cash balance approach.
• Explain the types, causes and effects of inflation and the monetary and fiscal measures to control it.
• Identify the four phases of a trade cycle and explain how public investment can start recovery.

Before you start

• National income and aggregate demand from Units 2 to 4.
• How demand and supply determine price, from Class 11 Economics.
• Rearranging a simple equation such as \(MV = PT\).

Monetary Economics explained

Money, Prices and Trade Cycles

Evolution and Functions of Money

Exchange moved from barter to commodity money, then metallic money (gold and silver standards), paper currency, and on to bank money, plastic money such as debit and credit cards, and digital and crypto currencies such as Bitcoin. Barter failed mainly because of the lack of a double coincidence of wants, the absence of a common measure of value and the difficulty of storing wealth.

The functions of money are grouped as follows.

• Primary functions: medium of exchange and measure of value.
• Secondary functions: store of value, standard of deferred payments and transfer of value.
• Contingent functions: basis of the credit system, distribution of national income among the factors of production, equalising marginal utilities and productivities, and giving liquidity to wealth.

Money Supply

Money supply is the total stock of money held by the public at a point of time. The RBI uses four measures:

• \(M_1\) = currency with the public + demand deposits with banks + other deposits with the RBI
• \(M_2\) = \(M_1\) + savings deposits with post office savings banks
• \(M_3\) = \(M_1\) + time deposits with commercial and cooperative banks
• \(M_4\) = \(M_3\) + total post office deposits

\(M_1\) and \(M_2\) are narrow money; \(M_3\) and \(M_4\) are broad money. Liquidity falls from \(M_1\) to \(M_4\). The amount of money that banks can create depends on the currency-deposit ratio, the reserve-deposit ratio and RBI requirements such as the Cash Reserve Ratio and the Statutory Liquidity Ratio.

Quantity Theories of Money

Irving Fisher's transactions approach is written as \(MV = PT\), where M is the quantity of money, V its velocity of circulation, P the price level and T the volume of transactions. If V and T stay constant, P changes in direct proportion to M: double the money supply and the price level doubles.

The Cambridge cash balance approach, developed by Marshall, Pigou, Robertson and Keynes, looks instead at the demand to hold money. It asks what fraction (k) of their real income people want to keep as cash. Here money is treated mainly as a store of value, while Fisher treats it as a medium of exchange.

Inflation, Deflation and Their Control

Inflation is a persistent rise in the general price level. By speed, it is classified as creeping, walking, running, and galloping or hyperinflation. By cause, it is demand-pull (too much money chasing too few goods) or cost-push (rising wages, raw material costs or profit margins pushing prices up). Deflation is a persistent fall in the price level. Stagflation is inflation together with stagnant output and high unemployment.

Inflation hurts creditors and fixed income earners, while debtors and business people often gain. To control it, the RBI uses monetary measures such as raising the bank rate and repo rate, raising the CRR and selling securities in open market operations. The government uses fiscal measures such as cutting its expenditure, raising taxes and increasing public borrowing.

Trade Cycles

A trade cycle is the regular rise and fall of economic activity in a capitalist economy. It has four phases: boom (high output, employment and prices), recession (the turning point, when investment and demand start to fall), depression (the lowest point, with heavy unemployment and low prices) and recovery (demand and investment revive). Recovery can be started by autonomous investment, especially public investment by the government.

Common mistakes to avoid

• Calling a one-time price rise inflation. Inflation is a continuous, sustained rise in the general price level.
• Thinking broad money is more liquid than narrow money. It is the reverse: \(M_1\) is the most liquid, and \(M_3\) and \(M_4\) add less liquid time and post office deposits.
• Confusing deflation with disinflation. Deflation is a fall in the price level; disinflation is a slowdown in the rate of inflation, with prices still rising.
• Treating the Cambridge approach as the same as Fisher's. Cambridge focuses on the demand to hold cash; Fisher focuses on the volume of transactions and velocity.
• Assuming every kind of inflation is harmful. Mild, creeping inflation is generally considered safe and can encourage producers; running and hyperinflation are the damaging kinds.

Test yourself on these with the practice test, then check the worked reasoning in the solved MCQs.

Frequently asked questions

What is the difference between narrow money and broad money?

Narrow money is \(M_1\) and \(M_2\): currency with the public, demand deposits, other deposits with the RBI, and post office savings deposits. Broad money is \(M_3\) and \(M_4\), which add time deposits with banks and total post office deposits. Narrow money is more liquid.

How does Irving Fisher's quantity theory of money work?

Fisher's equation is \(MV = PT\). If the velocity of money (V) and the volume of transactions (T) are constant, the price level (P) moves in direct proportion to the money supply (M). Doubling M doubles P, and halving M halves P.

What is the Cambridge cash balance approach?

Developed by Cambridge economists such as Marshall, Pigou, Robertson and Keynes, it explains the value of money through the demand for money. People hold a fraction of their real income as cash. The price level depends on the money supply relative to this demand, so money is treated as a store of value.

What is the difference between demand-pull and cost-push inflation?

Demand-pull inflation happens when aggregate demand is greater than the supply of goods, which is described as too much money chasing too few goods. Cost-push inflation happens when costs of production rise, for example wages or raw material prices, and firms pass the higher costs on as higher prices.

What is stagflation?

Stagflation is a combination of stagnation and inflation: prices keep rising while output growth is slow and unemployment is high. It is hard to handle because measures that reduce inflation can worsen unemployment, and measures that raise demand can push prices up further.

How can the RBI control inflation using monetary policy?

It reduces money supply and makes credit costlier. It can raise the bank rate and the repo rate, raise the Cash Reserve Ratio so banks have less to lend, and sell government securities in the open market to absorb cash from the system.

What are the four phases of a trade cycle?

Boom, recession, depression and recovery. In a boom, output, employment and prices are high. Recession is the turning point when investment starts to fall. Depression is the lowest point, with heavy unemployment. In recovery, demand and investment revive, often helped by public investment.