Saturday, April 30, 2011

Inflation and Deflation

Inflation may be defined as a rise in price level of all commodities in general. Effect of inflation on aggregate demand, and consequently on total production and income cannot be underestimated or ignored. A sustained trend of rising prices, or excessive growth of money income which surpasses the growth of real output, is the basic characteristic of inflation. Thus more money is required to buy the same quantity of a particular commodity. Real productivity fails to keep pace with price rise. The value of money keeps on falling.

Deflation is characterized by a falling tend in the general price level. This happens because of a fall in the aggregate demand. Deflation leads to increased unemployment, as there is a fall in investment due to a pessimistic behaviour on the part of investors. They invest less as the prospect of earning revenue is bleak. This causes unemployment and generates less income. Less income causes less demand.

Depression: If deflation comes at a time when there is sufficient unemployment in the economy, it is called Depression. It has a spiraling negative effect on the economy, and it becomes really difficult to boost it up.

Prof. Paul Samuelson has summarized inflation and deflation in the following words:

"By inflation we mean a time of generally rising prices for goods and factors of production - rising prices for bread, cars, haircuts, rising wages, rents, etc. By deflation we mean a time when most prices and costs are falling."

When money income in the hands of consumers increases, they acquire more purchasing power. The output of goods and services fail to keep pace with the purchasing power. More and more money runs after the same quantity of goods. This pushes up the demand, and consequently prices and costs of other factors of production. If production of consumer goods is cut down, then also there will be a situation of purchasing power, money income or effective demand outstripping actual supply. This will also push up the prices.

Once full-employment has been achieved, any increase in aggregate demand will push up the prices, leading to an inflationary situation. In such cases the economic infra-structure needs expansion. Additional production facilities, backed up by adequate investment, public (Govt.) or private, need to be generated to meet the rising demand.

Inflation may be of two basic types.

1. Demand-pull inflation: When effective demand overreaches actual supply, it is a case of demand-pull inflation. More money and fewer goods lead to a rise in prices.

2. Cost-push inflation: When costs of factors of production, like rent, wages and interest start rising spirally, it is a case of cost-push inflation. The cost of producing one unit of a commodity increases. This increases the market price of that commodity, which leads to inflation.

Stagnation: A period of no growth, or excessive slow growth of the economy, in terms of the gross domestic product, is termed as stagnation.

Stagflation: It is a situation where the economy is not growing, or growing at a negligible rate it terms of gross domestic product, but prices are increasing. It is characterized by persistent high inflation combined with high unemployment and stagnant demand.

An economic growth rate of 2%-3% or less is considered to be negligible.

Also read: Demand-Pull Inflation Cost-Push Inflation Effects of inflation

Tuesday, April 26, 2011

Role of Fiscal Policy and Monetary Policy

In reality there is always a gap between expectation and actual achievement. For a particular nation also this is true. There always remains a gap between actual GNP and potential GNP. (GNP = Gross National Product) The GNP that is produced in a particular year and the GNP that the economy is capable of producing, had there been high employment, optimum capacity utilization or maximum utilization of the available resources, are never equal. Even under favourable conditions, actual GNP falls short of the potential GNP. There is some wastage of scarce resources. Maintaining a steady growth with full employment and price stability is very difficult.

Fiscal Policy

When the economy does not function properly under the influence of unemployment, depression or inflation, the government tries to make certain changes in its expenditure policy to bring in the desired changes, and to eliminate the forces that are destabilizing the economy.

There are two basic measures that a government can undertake to stabilize the economy.

1. Government Expenditure

Increase in government expenditure acts as an investment. It gets added to the private investment that is prevailing in the economy. Thus, more government expenditure generates more employment and income, and takes the economy to a new equilibrium position.

C = consumption Expenditure
I = Private Investment Expenditure
G = Government expenditure
C+S+T = the income line of the community

FF is the full-employment line. It shows the society's maximum output capacity. The equilibrium is at point E. The society is not utilizing its full resources. This is known as under-employment equilibrium between investment and expenditure.

If the government tries to reach full-employment equilibrium, it will spend more money. As a consequence, the C+I+G curve will shift to a new position, C+I+G'. The full-employment level is reached at point F'. The government increases the expenditure by ΔG, and the national income increases by ΔY.

2. Taxation

Government Expenditure expands the economy, whereas taxation contracts the economy. More taxation reduces the disposable income of individuals. This reduces their capacity to spend on consumer goods. A rise in taxes lowers the C+I+G schedule or curve. This reduces income and employment. This is necessary during periods of inflation, when prices are moving upwards.

A reduction in taxes will give more income in the hands of consumers. Demand will increase, and new investment and income will be generated. This is necessary during periods of depression. Cut in taxes helps the economy to recover from a depressed state.

In a full-employment situation, increase in government expenditure will increase the income. But the economy cannot produce more to meet this extra demand, as it is already in a full-employment situation. Under such circumstances, prices will rise, leading to an inflationary situation. Then it is necessary to raise the taxes to take the extra income away, so that prices may not rise.

Similarly, lowering of government expenditure will lower the income, and effective demand. This may push the economy towards depression. So, with lowering of government expenditure, a reduction in taxes is necessary to maintain the same level of income and effective demand.

Monetary Policy

Monetary policy is aimed to control the supply of money in an economy. The central bank, which acts as the agent for the government, determines and controls the money supply according to the need of the economy. Objectives of monetary policy are as follows:

1. Price Stabilization
2. Move towards full-employment

3. Rapid growth rate

4. Stabilize the capital market
5. Favourable balance of payments.

Measures adopted to control money supply

1. Changes in cash reserve ratio
2. Changes in bank rate
3. Open market operations
4. Selective credit control
5. Moral persuasive measures

These two policies may be used in combination by the government to get the desired result.

Also read: Automatic Stabilizer and Discretionary Fiscal and Monetary Policy

Monday, April 25, 2011

Induced Investment and Thriftiness

In the topic Autonomous Investment and Thriftiness we have assumed that investment is independent of national income. That is not true. The investment schedule is not a straight line parallel to the X-axis. In reality entrepreneurs undertake more investment if sales and profit prospects improve. Thus they are induced to make more investments to satisfy the growing demand that influences the market. Even in the short run, the investment schedule takes the shape of a rising curve. More investment will generate more income and employment. Opportunities will increase, and producers will be induced to invest and produce more.

If we introduce induced investment with thriftiness the situations becomes worse than what it is with autonomous investment.

IpIp is the induced investment curve. It depends on the rate of change of GNP (Gross National Product). So the induced investment function is upward sloping. Ip stands for induced private investment. SS is the initial savings function, which cuts the induced investment function IpIp at E. An increase in thriftiness means an upward shift of the savings function SS to S'S'. F becomes the new equilibrium point. This corresponds to a lower level of income, OYf.
1. Aggregate savings goes up by ΔS.

2. As a result, national income falls by -ΔY.

3. Consequently, savings and investment will also fall from S = I to S' = I'.

An increased desire to save leads to a fall in savings due to a fall in income.

The Paradox of Thrift

Thus the policy of thriftiness is self-defeating. People want to save more but due to a fall in income, the savings also comes down. An increase in thriftiness leads to a fall in income, since the multiplier process acts in the negative direction. This leads to a fall in savings. So the society, at the end, saves less, not more.

Must also read: Autonomous Investment and Thriftiness

Monday, April 18, 2011

Autonomous Investment and Thriftiness

Thriftiness

Thriftiness means an increased desire to save or a decreased desire to consume. In other words, it implies an upward shift of the savings function, or what comes to the same thing as a downward shift of the consumption function. b↓ + s↑ = 1, where b = Marginal Propensity to Consume, and s = Marginal Propensity to Save.

The classical economists argue that thriftiness is beneficial for the society. This is because more savings means more capital formation, and more output of consumption and capital goods.

This view was challenged by Mr. J. M. Keynes and he said that if the economy is in depression, the problem is one of raising the effective demand. Under this situation, an increase in thriftiness means a fall in demand and ultimately a fall in income through the multiplier.

Autonomous investment and Thriftiness

Autonomous investment is completely elastic, as it has no relationship with Gross National Product (GNP) or its rate of change. Level of autonomous investment depends upon rate of interest and marginal efficiency of capital.

SS is the original Savings function where OYe is the National Income. II' is the Investment Function. Aggregate Savings S = s(Y), where s = MPS or marginal Propensity to Save. E is the equilibrium point where savings = investment. When savings is equal to investment, national income is equal to national expenditure. Therefore, OYe is the equilibrium level of income.

If there is an increase in thriftiness or an increased desire to save, the savings function will move upwards to S'S'. Then EF measures the increase in savings (ΔS) at the same level of income. Income remains the same but savings increases, resulting into a reduction in consumption. Now the new Savings Function, S'S', cuts the Investment function II' at G. So G is the new equilibrium point and it corresponds to a lower equilibrium level of income, OYg. Therefore national income falls by ΔY, due to an increase in savings by ΔS.

So savings is damaging to the economy. Ultimately, it lowers the income.

Must also read: Induced Investment and Thriftiness

Wednesday, April 13, 2011

Purpose Of Keeping Accounts

Generally people have a short memory, and businessmen are no exceptions. They have to do many transactions daily. A businessman gives cash to and receives cash from a number of suppliers and customers. He purchases and sells goods and other articles for cash and on credit. He incurs a number of expenses daily and earns income from different sources. At times he sells business properties, which are no longer required, and at other times makes additions to properties already existing. He cannot remember for long all the varied transactions taking place daily in his business. He must, therefore, make a written record of his varying transactions, so that in times of need he may refresh or supplement his memory by referring to his written records. In other words, he should keep accounts.

Book Keeping is the art of recording daily business transactions regularly in a set of books, following a definite system.

- Only the transactions of a financial nature are recorded.
- The recording of transactions is made in a definite set of books specially designed for the purpose.
- Records are maintained date-wise.

Accounting: Accounting is preparation of statements or accounts in a summarized and classified manner to find out the profit or loss, and to ascertain the financial position of the business. Accounts are maintained in a "T" form.

Meaning of DEBIT and CREDIT: The left hand side of each account (utilized for recording transactions in respect of which that account has received benefit) is called the "debit" side, and the recording of transactions on the debit side of any account is technically known as "debiting an account". Thus, to debit an account means to enter the transaction on the debit (left) side of that account.

Similarly, the right hand side of each account (utilized for recording transactions in respect of which that account has given benefit) is called the "credit" side, and the recording of transactions on the credit side of any account is technically known as "crediting an account". Thus, to credit an account means to enter the transaction on the credit (right) side of that account.

Double Entry System of Book Keeping: Every business transaction has a two-fold effect. It affects two different accounts in opposite directions. A complete record of any transaction would, therefore, require the entry to be made in both the accounts, debiting the one and crediting the other. This recording of the two-fold effect of every transaction is known as Double Entry. According to William Pickles, the two-fold effect of every transaction is recorded under double entry system - one effect being the receiving of some benefit, and the other being the giving of some benefit. In other words, every transaction involves two accounts, a receiving account and a giving account. The receiving account is debited and the giving account is credited.

Trial Balance: At the end of  the financial period, which is normally a year, (may be less) if the debit and credit sides of every ledger account is totalled and all accounts' individual balancing figures, either debit balance (debit side heavier) or credit balance (credit side heavier) are taken into consideration and columned up into two debit and credit columns, their totals should tally, since every debit has a corresponding credit under double entry system of book keeping.. This statement is called trial balance. A trial balance should always tally (total of debit balances = total of credit balances) irrespective of when it is prepared.

Manufacturing account and trading account: A manufacturing concern needs to prepare a manufacturing account as well as a trading account. A trading account is required to be prepared by all.

In the manufacturing account (in the same "T" form) all manufacturing expenses' balance from the trial balance are written. This total gives the total manufacturing cost.
All expenses always have a debit balance. So these manufacturing expense accounts in the ledger are closed
by transferring them to the manufacturing account thus:

Respective Expense account
 - credit side: By manufacturing account      say 20,000
Manufacturing account 
- debit side: To respective expense account           same 20,000  (double entry completed, and the respective expense account gets closed, with no balance)
Total of all manufacturing expense balances thus get transferred to the manufacturing account. Now the manufacturing account has all debits which gives a total, say 5,00,000. Then the manufacturing account is closed by transferring this debit balance total of 5,00,000 to the trading account in the folowing manner.

Manufacturing account
 - credit side: By Trading account   5.00,000

In the trading account the manufacturing cost (as ascertained from the manufacturing account) is tranferred by completing the double entry thus:
In trading account 
- debit side: To manufacturing account   5,00,000. Just balances get rolled over from one account to the other.
If it is not a manufacturing concern, then there will be no Manufacturing Account, but only Trading Account.
Then,
In trading account 
- debit side: To Purchases account   5,00,000.  (from trial balance, Purchases account debit balance)
Now other "direct" trading expenses (wages, carriage inward etc), again from the trial balance, are posted in the Trading accont thus. (the same way as all the manufacturing expenses are posted in the manufacturing account above.)

In trading account 
- debit side: To respective expense account balance from trial balance  say, 10,000 (there may be multiple trading expenses. Same treatment for each.)

Trading account Total now comes to say 5,00,000 + 10,000 + 5,000 + 25,000 = 5,40,000

In the credit side of the trading account we write: By sales account  say 7,50,000 (this 7,50,000 sales account credit balance figure again comes from the trial balance)

The balancing figure 7,50,000 - 5,40,000 = 2,10,000 is the gross profit earned. Had sales been less than 5,40,000 (say 5,00,000) it would have resulted in a gross loss to that extent (40,000).

Again rolling this gross profit or gross loss to the next account, namely Profit and Loss Account, takes place thus:

In Trading Account 
Credit side
- By Profit and Loss account  2,10,000 (gross profit transferred to P/L account)
or
Debit side
To Profit and Loss account  40,000 (gross loss transferred to P/L account)

Profit and Loss Account: Remaining indirect expenses' and indirect incomes' account balances, again from the trial balance, are transferred in the same way in the Profit and Loss account.

Profit and Loss Account
-----------------------------------------------------------------------
To Trading account  (gross loss)     40,000    OR  By Trading account (gross profit) 2,10,000 
To other respective indirect expense    2,000               By other respective indirect income 500
---- more -----                                                   --- more ----

Balancing figure gives net profit or net loss which is either debited (if loss) or credited (if profit) to the Capital Account.
----------------------------------------------------
                                 Balance Sheet
Liabilities                            |                     Assets

Now in the trial balance, the balances that remain unused are all either assets or liabilities. Those are put here. Total assets (machinery, furniture, cash/bank, money receivable etc) must always be equal to total liabilities (internal:  liability of the business towards the owner, that is the capital contributed by them(shares etc), AND external: towards outsiders, like money payable)

Total assets must always be equal to total liabilities.

This finishes the Final Accounts part, where somewhere or other every ledger account balance, either debit or credit, as shown in the trial balance, must necessarily have been used.

The owner now know the profit or loss, as shown in the Profit and loss Account, and the financial position of the company, as shown by the Balance Sheet.

Hierarchy of preparation: Trial balance, Manufacturing account, Trading Account, Profit and Loss Account and Balance Sheet.
-------------------------------------------
Golden rule of accountancy

There are basically three types of accounts
1. Personal account:
                      Debit    : the receiver of benefit
                      Credit   : the giver of benefit

2. Nominal  account: ( All expenses and incomes)
                      Debit : All expenses and losses
                     Credit : All incomes and gains

3. Real Account: All assets and liabilities
                      Debit: what comes in
                      Credit: What goes out.
--------------------------------------------------------------------
Trial Balance is prepared on a particular date.

Manufacturing, Trading and Profit and Loss Accounts are prepared for a particular period.
                    say, for the year ended March 31, 2014

Again, Balance Sheet, showing the financial position of the company, is always "as on a particular date."

Up to maintenance of ledger accounts, that is journal entry, double entry ledger posting, it is book keeping.
Preparation of Trial Balance, Manufacturing, Trading, Profit and Loss account and balance sheet is accounting. Accounting starts where book keeping ends.

------------------------------------------------------------------------
Simply, every account is like a tank. One side dumping/recording the "in(s)" and the other dumping/recording the "out(s)", and then finding the balancing figures and working with those balancing figures, starting from preparation of Trial Balance.


Tuesday, April 12, 2011

Simple Income Determination with Savings-Investment Equality

National income is the sum total of consumption and savings. It is the money value of all commodities and services produced in the economy. These commodities and services are of two types.

1. Supply of consumption goods and services

2. Supply of Capital (investment) goods and services.

'Y' is the aggregate supply because it is the sum total of consumption and savings. Y = C + S. To this we add tax collected (T), which is the income of the government. Then the equation becomes Y = C + S + T.

Expenditure 'E' means aggregate demand. It is composed of aggregate consumption expenditure, or demand for consumption goods and services, as well as aggregate investment expenditure, or demand for investment goods and services.
Thus E = C + I. To this if we add government expenditure (G), then the equation becomes E = C + I + G.

We know that at equilibrium, income is equal to the expenditure for the economy as a whole.

In the whole model, where there are three sectors, the consumers, the business firms and the government,

1. Income = consumption + savings + Tax. Y = C + S + T - This is the supply side.

2. Expenditure = consumption Expenditure + private Investment Expenditure + Government Expenditure - E = C + I + G. This is the demand side.

If Y = E, then C + S + T = C + I + G

In an equilibrium position, government income, in the form of tax, is equal to government expenditure. T = G.

C + S + T = C + I + G. 'C' cancels out from both the sides, and T = G. Then, as because income 'Y' is equal to expenditure 'E', savings = investment, or S = I. This is known as the equilibrium condition of the national income. This can be shown with the help of the following diagram.

We initially draw a 45 degree line OY where Y = C + S + T. This is the income line of the community. At any point on this line, income = expenditure, or every point is a point of national income equilibrium. I-I' is the fixed level of autonomous investment, irrespective of the level of national income.

Now if we merge the Y = C + S + T supply (income) schedule, the 45 degree line, and the demand (expenditure) schedule E = C + I + G, we can arrive at the equilibrium position.

The savings curve is upward sloping, because with every increase in income, savings increases. Refer to the Savings function in earlier posts.

E is the equilibrium point.

At point F, aggregate demand is greater than aggregate supply. So prices will go up. More goods will have to be produced in order to meet the excess demand.

FF' measures excess of expenditure over income. This is known as the Inflationary Gap. It shows that the community is attempting to consume more than what it is capable of producing. Due to this excess demand, prices will go up, and further production will be profitable. If production increases, National Income will also increase, until the equilibrium level of income is reached.

At point G, income is greater than expenditure, and GH measures what is called Deflationary Gap. The community is consuming less than what it is capable of producing, or demand is less than the supply. Producers are now faced with the problem of unintended accumulation of inventories. As a result prices will fall, and production will also fall, until the inventories are run down completely. In the process it will come back to the equilibrium point E. At the equilibrium point prices will be stable, because there will be neither inflation nor deflation.

Monday, April 11, 2011

Induced Investment and the Accelerator

The proportion of Gross National Product (GNP) that enters into investment goes a long way to determine the economic growth of a country. Autonomous investment is determined by rate of interest and marginal efficiency of capital. It does not change with the change in national income. However, the other type of investment, namely Induced Investment, varies with the national income. With every increase in National Income, induced investment keeps on increasing. It is called 'Induced' because a change in National Income induces a change in investment.

Example: National Income changes from $1,000 billion to $2,000 billion, and induced investment changes from $200 billion to $400 billion

Change in National Income = ΔY = $1,000 billion

Change in induced investment = ΔI = $200 billion

Then, Marginal Propensity to Invest (i) = ΔI/ΔY = 200/1000 = 1/5

Change in Induced Investment divided by change in National Income gives us the Marginal Propensity to invest, denoted by 'i'.

Example:
The accelerator shows the accelerated effect on investment due to a small change in output or sales. 'v' is the accelerator or capital/output ratio. It shows the amount of capital required to produce one unit of output.

When output increases by 25 units, from 75 to 100, and the value of 'v' is 2, capital stock must increase by 50 units. This increase in capital stock is nothing but investment.

Thus, induced investment depends on the rate of change of GNP and the accelerator. If sales or output fails to increase period after period, no new investment will be undertaken. Therefore, for net investment to be positive, it is essential that output must not only be high; it should be changing. This is the Acceleration Principle.

The Accelerator illustrated
Net investment = change in capital (requirement) stock

We assume that there is a constant rate of depreciation of $10 per unit. Gross investment is net investment + depreciation.
A small change in output will lead to an accelerated change in investment. When output increases by 20%, gross investment increases by 200%. For every 1% increase in output, there is a 10% increase in gross investment.

When output fails to increase in the 6th year, gross investment drops down by 75%.

If output starts falling, net investment will be negative, and the firm will start selling some of its capital equipments. Gross investment will take place to the extent of depreciation only.

The accelerator is a very powerful factor and it works with the multiplier in causing cyclical fluctuations in business activities.

Friday, April 8, 2011

Autonomous Investment

Autonomous investment is that investment which is independent of the national income. It takes place on its own, without bearing any relationship to Gross National Product or its rate of change. If we analyze the factors that govern autonomous investment, then we will clearly understand why it is autonomous. Autonomous investment depends upon two major factors.

1. Rate of Interest 2. Marginal Efficiency of Capital

1. Rate of Interest: Rate of interest is the cost of borrowing money in order to acquire an asset, or if funds are available, then the income or opportunity, in the form of interest, foregone to acquire the asset. The later is called the opportunity cost of investment.
Investment is inversely related to rate of interest. The higher the rate of Interest, the lower will be the level of autonomous investment. A fall in the rate of interest will bring in fresh investment. Fresh investment will increase income through the multiplier, and employment will consequently rise.

2. Marginal Efficiency of Capital: It is basically concerned with the rate of return from the investment. Investor's expectation from future earnings from the investment must always be greater that the cost of borrowing the necessary funds, required to acquire the asset. This expectation is largely dependent on present level of expenditure and consumption. If these are high, then the investor will have an optimistic view of the future. He will invest.

So long as the present value of future earnings from the asset is equal or greater than the acquisition cost of the asset, the producer will invest. Marginal efficiency is basically a rate, at which future yields, expected from one additional unit of an asset, must be discounted, so as to make the total yield at least equal to the acquisition cost of the asset.
Marginal efficiency of capital, within a given period of time, keeps on diminishing for any given kind of asset. This is because anticipated yields from the asset will diminish, as more and more of the asset in put into use. Secondly, the acquisition cost of the asset will increase as more and more of that asset is purchased by producers.

The concept of autonomous investment was developed by Mr. Keynes. He said that autonomous investment would be positive, so long as the marginal efficiency of capital is greater than the rate of interest. So long as mec > i, fresh investment will take place. If the market rate of interest remains unchanged at oi, and the marginal efficiency of capital starts falling with the application of more and more capital, a stage will be reached when when mec = i. This is shown by the point E, where the producer will reach his optimum level of investment. This occurs due to the Law of Variable Proportions.

Investment - An Overview

Investment Function

National income is denoted by Y. It has two components, consumption(C) and savings(S). A part of the income is spent on consumption. That which is not spent is obviously saved. It may or may not be invested.

So we can say that Y = C + S

C is the supply of consumption goods and S is the supply of savings. This is the supply side of the picture.
National income is basically the money value of all goods and services produced in an economy during an accounting year. Total goods produced or total production is the sum total of consumption goods and capital goods. The total expenditure of the community is denoted by E. It means aggregate expenditure or effective demand. Aggregate expenditure is called effective demand because whatever is spent must be backed up by an equivalent demand.

So we can also say that E = C + I

C is the demand for consumption goods, or expenditure made by the household sector. I is the demand for investment made by the private firms. This is the Demand side of the picture.

National Income is said to be in equilibrium when the country spends as much as it earns, or when income is equal to expenditure. That means when the supply side Y = the demand side E.

Y = E Or, C + S = C + I

C cancels out from both the sides of the equation, leaving S and I on either side, which are equal.

That is, S = I. So the major point is that Savings (S) is equal to investment (I), only when the national income is equal to national expenditure. Gross national income is the money value of Gross National Products (GNP).

Investment is the second broad component of GNP. Although savings = investment, there is a relationship between savings and investment. Savers save more when the rate of interest is high, and investors invest more when the rate of interest is low. Although savings is equal to investment, savings is positively related to rate of interest, and investment is negatively related to it.
Definition: Investment refers to the change in the stock of capital either of the economy or of a business firm between two periods.

Dual Aspects of Investment: Investment is a form of expenditure and a source of demand. We know that E = C + I. Investment also shows the change is the stock of supply of capital. By adding to society's stock of capital, we enable it to produce more of both consumption goods and capital goods in future.

Gross Investment and Net Investment

Here D means depreciation. Gross investment less depreciation provides us with net investment or net capital formation.
Depreciation is defined as the reduction or depletion in the value of an equipment due to its contribution to the production process. It includes normal wear and tear.

Wednesday, April 6, 2011

Multiplier Theory of J. M. Keynes

We know that there are two key concepts Marginal Propensity to consume (MPC), and Marginal Propensity to Save (MPS). What is not consumed is automatically saved, and what is saved, a part or whole of it is automatically invested. The savings in done by the consuming, household sector, and the investment is done by the producing sector.

Change in Income(ΔY) = $100
Change in Consumption(Δ) = $80,
Change in Savings(ΔS) = $20

We also know that ΔY = ΔC + ΔS
Dividing both sides by ΔY,

We get ΔY/ ΔY = ΔC/ΔY + ΔS/ΔY

Or, 1 = ΔC/ΔY + ΔS/ΔY

Or, 1 = 80/100 + 20/100
Or, 4/5 + 1/5 = 1
Or, b + s = 1

We can now use an imaginary table.

Prof. Keynes introduced two major inferences.

1. If income increases, consumption will also increase, but less than proportionately (as part of the change in income is saved.)

2. The Marginal Propensity to Consume (MPC) is less than Average Propensity to Consume (APC). Average Propensity to Consume is Total Consumption divided by Total Income.

The Multiplier

b + s = 1
Or, s = 1 - b

Or, 1/s = 1/(1-b) = the multiplier "m".
"m" is the reciprocal of the marginal Propensity to Save.
m = 1/s = 1/(ΔS/ΔY) = 1/{1-(ΔC/ΔY)}

According to Mr. Keynes, the change in income ΔY = multiplier times change in investment, ΔI.

According to our above example, b = 4/5 and s = 1/5

Therefore, m = 1/s = 1/(1/5) = 5

ΔY = m(ΔI)

If investment changes by $100, then income changes by

ΔY = 5($100) = $500

Thus if investment increases, national income will also increase, not by the same amount, but by a multiple of it. Another point made by Prof. Keynes was that if the consumption expenditure of the community increases, the value of "b" will be larger and larger, and so also the value of the multiplier, and so also the national income.


The multiplier is the reciprocal of Marginal Propensity to Save. Corresponding to each value of "b" there will be a particular value of "s", and corresponding to each value of "s", there will be a particular value of "m".
Change in income ΔY = multiplier (m) times change in investment, ΔI

The Logic of the Multiplier
According to Mr. Keynes, the multiplier means that a small increase in investment will lead to a multiple increase in income. One man's expenditure is another man's income, and vice versa. When a man spends a part of his income, say $X, he creates an income of others of $X. The second person will again save a part of $X, and spend the rest. Again, the second man's expenditure creates an income for the third person. Thus the same money goes on creating incomes for a number of persons. This process leads to the following equations, where "b" is the part of the income spent, or MPC.


Larger the value of "b", greater will be the change in income.
The root cause of unemployment is deficiency in demand. And the only way to stimulate the economy in depression is to increase the demand through public or government expenditure programmes. Fresh expenditure will generate new incomes, and the multiplier process will set in. The multiplier effect will ultimately restore the full-employment situation.

Assumptions: In order to explain the Multiplier theory Mr. Keynes made the following assumptions:

1. Consumption always changes with change in income. In other words, consumption will always depend on income.

2. Marginal Propensity to Consume will remain constant.

3. There is change in Autonomous Investment. Autonomous Investment means when investment takes place even when there is no increase in income.

Limitations: The following factors will set a limit to the working of the multiplier.

1. Leakages: The higher the Marginal Propensity to Consume, the higher will be the value of the multiplier. The income, which is received, should be spent, so that it may again come back as income. If people prefer to keep cash balances idle, for transactions, precautionary or speculative motives, income created will naturally be less.

2. Consumption Goods: With the rise in income, consumption goods should be readily available in sufficient quantities, so that additional income may be spent on them. If there is shortage of goods, additional income received may not be fully spent. The Marginal Propensity to Consume will be low, and therefore the multiplier will be low.

3. Multiplier Period: The time gap between the receipt of income and consumption expenditure is known as the Multiplier Period. The smaller the time span of the multiplier period, the higher will be the value of the multiplier.

4. Investment: Any increase in investment in one sector should not be accompanied by a decrease in investment in another sector. Increments in investments should be repeated at regular intervals.

5. Full Employment Ceiling: If the economy is working at or near full-employment level, fresh investment outlay cannot lead to an increase in the supply of consumption goods. It will not raise aggregate income but will lead to price rise. Full-employment situation is called the economy's inflation threshold.

6. Induced Investment: Just as a change in investment induces consumption, so also induced consumption can influence investment. But the multiplier effect does not take this into consideration.

Conclusion: Though there are some limits in the workings of the multiplier, Mr. Keynes used this concept to advocate public investment during a period of depression.


Must also read: 1. Consumption and savings

2. Consumption Function and Savings Function

Consumption Function and Savings Function

Before reading this, read: Consumption and Savings

1. Consumption Function
The income identity is Y = C + S (income = consumption + savings)

C = a + b*Y Or, C = a + (ΔC / ΔY)*Y

MPC or Marginal propensity to Consume is "b". Y is the total income and b = ΔC / ΔY
In the diagram, "a" is the minimum consumption necessary to maintain oneself even at zero income. Now suppose the income increases to B. So AC is our familiar ΔY (change in income). Income increases from O to Yo, which is equal to AC. BC measures change in consumption ΔC, which is the resultant increase in consumption due to an increase in income.


2. Savings Function


MPS or Marginal Propensity to Save is "s". Y is the total income and s = ΔS / ΔY

Income multiplied by Marginal Propensity to Save or MPS or "S" will give us the total savings of the community.

Any point below the point B shows negative savings. B is called the break-even point or the point of zero savings. This means at point B, income = consumption and MPC = 1, as because MPS = 0.

The economic rationale is that at low levels of income people consume more than they earn. At a certain minimum level of income, income is exactly equal to consumption. This is the break-even point in consumption, where savings = 0. Thereafter, with every increase in income, savings goes on increasing. Therefore MPS or s = change in savings / change in income = ΔS / ΔY.

Tuesday, April 5, 2011

Consumption and Savings

Goods are of two kinds:

1. Consumption goods: These are goods, which people require for their day-to-day living. These goods get used up, or get consumed and hence the name. Example: toothpaste, exercise book, soap, television, mobile phone etc.

2. Capital goods: Capital goods are those goods, which help to produce consumption goods, or other capital goods. Example: machine that makes the toothbrush, or a machine that make the parts of another machine.

In 1931 Mr. R.F. Kahn noticed that one employment increases the total employment in the economy. For example, if there is employment in the construction of roads and bridges, this will increase the income of those who are employed in the construction works. As a result of this, demand for consumption goods will increase. When more consumption goods are demanded, it increases the price of consumption goods, assuming that supply remains constant. Consequently, when more consumption goods are sold, it increases the profit of the sellers. When profit increases, a part of it is reinvested to produce more consumption goods, as it is bringing in more profit.

Fresh investment creates more employment opportunities in the consumption goods industries. Again, for the production of more consumption goods, more capital goods, like machinery, will be required. So the production of capital goods will also increase. This will increase the employment in the capital goods industries.

Thus one employment in the construction works industry will increase the total employment in the economy.

Gross National Product is a measure of the performance of the economy of a country. It is called the yardstick of an economy's progress. A more reliable indicator is per capita income, which is national income per head. National income is said to be in equilibrium when it is exactly equal to expenditure.

National income is denoted by Y. It has two components, consumption(C) and savings(S). A part of the income is spent on consumption. That which is not spent is obviously saved. It may or may not be invested.

So we can say that Y = C + S

C is the supply of consumption goods and S is the supply of savings. This is the supply side of the picture.

National income is basically the money value of all goods and services produced in an economy during an accounting year. Total goods produced or total production is the sum total of consumption goods and capital goods. The total expenditure of the community is denoted by E. It means aggregate expenditure or effective demand. Aggregate expenditure is called effective demand because whatever is spent must be backed up by an equivalent demand.

So we can also say that E = C + I

C is the demand for consumption goods, or expenditure made by the household sector.
I is the demand for investment made by the private firms.
This is the Demand side of the picture.

National Income is said to be in equilibrium when the country spends as much as it earns, or when income is equal to expenditure. That means when the supply side Y = the demand side E.

Y = E
Or, C + S = C + I

C cancels out from both the sides of the equation, leaving S and I on either side, which are equal.

That is, S = I. So the major point is that Savings (S) is equal to investment (I), only when the national income is equal to national expenditure. Gross national income is the money value of gross national products.

Consumption: Consumption is basically the part of the income that is spent. It depends upon the disposable income (Yd). Disposable income means money income minus taxes paid.

So, Yd = Y - T

Y is the money income and T is the tax paid.

Therefore, consumption (C) is a function of disposable income (Yd).

C = f(Yd)

Consumption function: Propensity to consume: We know that Y = C + S. Delta (Δ) is the symbol used to denote change. If income increases byΔY, and consumption by ΔC, and savings by ΔS, then ΔY = ΔC + ΔS. Change in consumption due to change in income is called the consumption function. In 1936 Prof. J. M. Keynes stated in his book “The general Theory of Income, Interest and Money” that if income increases, consumption will alsoincrease, but not proportionately. For example, if the income of an individual increases by $100, consumption mayincrease by $80, and savings by $20. Here ΔY = $100, ΔC = $80 and ΔS = $20.

Marginal propensity to consume: Change in consumption induced by change in income is called Marginal Propensity to Consume.

We know that ΔY = ΔC + ΔS
Dividing both sides by ΔY,
we get ΔY/ ΔY = ΔC/ΔY + ΔS/ΔY
Or, 1 = ΔC/ΔY + ΔS/ΔY
Or, 1 = 80/100 + 20/100
Or, 4/5 + 1/5 = 1
Or, b + s = 1
“b” is the Marginal Propensity to Consume, and “s” is the Marginal Propensity to save.The sum of Marginal Propensity to Consume (b) and Marginal Propensity to save (s) is always equal to 1.

“b” can thus be defined as the ratio of change in aggregate consumption brought about by a change in national income. In a like manner we can define “s” as the ratio of change in savings to change in income, that brought it about.

According to Mr. Keynes as income increases, consumption also increases. Therefore “b” is always greater than 0 (b>0). But “b” always increases less than proportionately (b<1). Similarly “s” is always greater than 0 (s>0) but less than 1 (S<1).
Since b + s = 1, s = 1 – b. Savings is residual in nature.

“s” is the Marginal Propensity to Save.

Also read: Consumption Function and Savings Function

Monday, April 4, 2011

How to develop a liking for your studies and be a successful student

All students are not born with the same level of intelligence and diligence. In this respect students vastly differ from one another. A few remain glued to their text books and notes, while there are some who start studying seriously just 2/3 weeks before the examination. In between lies the vast majority of students who keep in touch with their studies as a routine affair without giving much thought to it, and somehow manage to get a presentable grade and pass out. The following is a very basic method to do well in studies. If a student is following any other methodology with success, he should NOT change it. There surely may be many other study methodologies which also work very well, or even better. A student must remember that success at school level determines how one will fare at the graduate level in college. The school level may be subdivided into three sections.

1. Junior school level Here the teacher plays the most important role which they do quite successfully. One will seldom find a kid who does not know how to count from 1 to 10, or who does not recognize the alphabets or colors correctly, or can't add 2 and 7. Here parents also play a major role.

2. Middle school level The middle school is the most important in a student's academic career. At this level his logical thinking starts growing and he either develops a liking for his studies, or does not, or remain somewhere in between. At this level the basic principles of Arithmetic, Geometry and Algebra are introduced. A student must know that Mathematics is the most important subject. It is very difficult to overcome any shortcoming, that remains at this level, in the high school level. A student must pay great attention to Mathematics at the middle school level. A student who gets a good grade in Mathematics seldom does badly in other subjects.

3. High school level A student's performance at the high school level depends upon what he has studied and learnt at the middle school level. If the foundation at the middle school level is good, a student will surely do well at the high school level. Most of the things, that are taught at the high school level, have their foundation laid at the middle school level. If a student does well at the high school level, he will surely do well in Graduate and Post-graduate level. RULE NUMBER 1 Liking or rather loving to study. What is the secret behind it ? Once a student starts liking and loving his studies, his job is almost half done. Students basically dislike studies because they don't find it interesting. They don't find studies interesting when they fail to grasp or understand the subject matter properly. Only then a student sets that subject aside. A STUDENT MUST NEVER SET ASIDE SOME SUBJECT MATTER HE HAS FAILED TO GRASP OR UNDERSTAND PROPERLY. A student must get all his doubts cleared, about any and every subject, anyhow, from his teachers, parents, or whoever. Once a student starts understanding his lessons well, he will surely develop a liking for his studies. That is sure. This liking-disliking aspect starts at the middle school level, starting most of the times with the subject Mathematics, and other science subjects.
So that is our RULE NUMBER 1. GETTING ALL DOUBTS CLEARED AT ONCE.

RULE NUMBER 2. In order to do well in examinations a student has to MEMORIZE his lessons well. THERE IS NO SHORT CUT METHOD FOR THIS. A student must work hard for this. Students tend to forget their lessons easily as they are playful. How to overcome that ? Here we will break up the subjects into three subdivisions.
1. Mathematics.
2. Other Science subjects, like Physics, Chemistry, Biology etc.
3. Remaining subjects English, History, Geography, etc.

1. For Mathematics, the only rule is, UNDERSTAND THOROUGHLY THE BASIC RULES AS TO HOW TO SOLVE A PROBLEM. He must fall back upon his teacher, or parent or whoever immediately, if he fails to understand the method properly. MEMORIZE THE METHOD. THEN, PRACTISE SOLVING SUMS AND PROBLEMS EVERY DAY, STARTING FROM DAY NUMBER 1. Solve a few sums and problems everyday, do it everyday. Take up sums and problems from various books and solve them. Try to move a bit ahead of your classroom lessons, if possible. This will help a lot during the examinations. This everyday-practice is necessary as Mathematics get erased from memory soon.

2. For other science subjects the rule is,

a) Understand the subject matter very thoroughly and clearly.

b) Take up a lesson. Break it up into manageable small parts(say two/three pages, max.five). By small parts it is meant that as much that can be completed in a session of two hours, plus-minus 30 minutes. Take up one such part and try to memorize it. Read it thoroughly, over and over again. At one point of time it will come to stay in memory. This is CALLED BUILDING UP A LAYER IN MEMORY.(BLM).

c) In the next session, when a student again takes up the same lesson, (within the next 2/3 days) he must try to recapitulate the previous session's part, and then take up a new part. One has to build up layers in his memory by recapitulating the lessons UNSEEN. Each time a student recapitulates a part, unseen, or partly seen and partly unseen, it builds up a layer in the memory (BLM). The more the number of layers, the more permanent it becomes in memory. One day it will surely become permanent. Next, a student should refresh the memory as and when he finds it necessary. This way he should complete each and every lesson. Before examination, say two months, a student should make a routine with date, time, and lesson/part of a lesson to be taken up on a particular date and time. He should strictly follow this routine.

3. For all other subjects also, he should do the same as stated in 2. (a), (b) and (c).

RULE NUMBER 3. STUDY EVERYDAY, MATHEMATICS, MOST CERTAINLY EVERY DAY. ON ANY PARTICULAR DAY, SOLVE MATHEMATICS (Sums and Problems) AFTER FINISHING STUDYING OTHER SUBJECT/SUBJECTS. He must not take up more than two/three subjects on a particular session. A student should not ignore any subject. He must try to develop a liking for ENGLISH as a subject. In his leisure hours, he must write essays sometimes, on various topics.

RULE NUMBER 4. At home, a student must review his progress himself by writing down his lessons from memory at times. This writing may not be possible for all the lessons of all subjects, that is true. He must do it as much as possible. Any part forgotten must immediately be refreshed in memory by opening the book and going through that portion. If a student finds it difficult to keep a particular lesson in memory, he should try to recapitulate it, as much as he can, from memory, at night in bed, before falling asleep.

RULE NUMBER 5. A student should study for six days a week. Relax on one day every week, if he feels confident that he can afford to do so. But once he starts liking his studies, he will find it difficult to stay away from books. A student must not think about all the subjects and the full study-load all at a time. Take one day at a time, or at the most 3 days at a time. A student must study at least six hours daily, broken up into two parts. Before examination it may have to be increased.

RULE NUMBER 6. A student must sleep well on the night before the examination. That will keep the nerves cool and active, and the memory fresh. Never stay awake on the night before the examination.

Knowledge brings happiness and a student must always have the courage to know.

Quantity Theory of Money - Cambridge Version and Friedman's Version

Quantity Theory of Money - Cambridge Version: The economists of Cambridge University such as Mr. Robertson, Mr. Pigou, Mr. Marshall and Mr. Keynes introduced a new version of the quantity Theory of Money. According to this version the value of money is determined by the demand for and supply of money, as the price of a commodity is determined by the demand for and supply of that commodity.

The equilibrium price is determined when the demand is equal to the supply. So the value of money will be determined when the demand for money is equal to the supply of money. Demand for money can be represented as Md and the supply of money can be represented by Ms.

There is a demand for money because money functions as a store of value. People want money because they want to hold money. This is known as Liquidity Preference. Thus the aggregate demand for money will depend on

1. Total transactions, - T
2. Price level - P, and
3. The portion of the total income which people want to hold - K.

This can be represented by PTK.
Supply of money depends on the quantity of money. It remains constant at any point of time. This can be represented by M. Therefore PTK = M.

From the above analysis we get the following equation.

Md = Ms.
That is, PTK = M
Or, P = M / TK. That means price level is equal to quantity of money divided by total transactions times portion of total income that people want to hold.

Comparison between American Version and Cambridge Version

If we make a comparison between the two versions of the Quantity Theory of Money, we find out that there are some points of similarity and distinction between the two.

Distinction: The following are the points of distinction between the two versions.

1. In the American Version they have emphasized on the function of money as the medium of exchange. But in the Cambridge Version they have emphasized money as a store of value.
2. In the American Version they have emphasized on the velocity of circulation of money; in other words on the movement of money. But in Cambridge Version they have emphasized upon the desire of people to hold money.
3. In the American Version the value of money is determined in a given period of time. In the Cambridge Version the value of money is determined at a point of time.

Similarity: If we analyze the American and Cambridge Versions of the Quantity Theory of Money, we can point out the following similarities between the two.

1. Both these versions more or less use the same symbols to explain the theory.
2. Both these versions tried to determine the value of money. According to these versions the value of money is determined by the quantity of money.

Conclusion: Of the Two Versions of the Quantity Theory of Money, the Cambridge Version is regarded as superior to the American version, because it is based on the General Theory of Value, which is accepted by all modern economists. However, from the academic point of view, none of the versions can be ignored.
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Quantity Theory of Money - Friedman's Version: In 1936 Mr. Keynes published his book, The General Theory of Employment, Interest and Money. After the publication of this book, the Quantity Theory of Money lost its popularity. In 1960, Milton Friedman of Chicago University tried to revive the importance of The Quantity Theory of Money. So he introduced a new version of the Quantity Theory of Money.

According to him there is a demand for money because men want to hold wealth. Hence the equation is

P = M / Dm

Where P is the price level,

M is the Quantity of money, and

Dm is the demand for money for wealth.

Sunday, April 3, 2011

Quantity Theory of Money

There are three versions of the Quantity Theory of Money.

1. American Version or the Cash Transactions Version or Fisher's Version.
2. Cambridge Version or the Cash Balance Version.
3. Friedman's Version.

1. American Version: According to Irving Fisher and others, the value of money is determined by the quantity of money. The value of money depends on the demand for and supply of money. There is a demand for money because money functions as the medium of exchange. Hence the demand for money depends upon the amount of goods and services, which the people want to purchase.

Thus the demand for money depends upon the total transactions in the economy and the price level. This can be represented by PT, where P = price level and T = total transactions.

The supply of money depends on the

a) Quantity of money
b) Velocity of circulation of money

The quantity of money includes the cash money and the credit money. This can be represented as M and M1. The velocity of circulation of cash and credit money can be represented as V and V1. From this analysis we get the following equation.

PT = MV + M1V1
Therefore, P = MV + M1V1 / T
Mr. Fisher tried to explain his theory on the basis of the assumption of full employment. Under full employment, supply of goods and services remain constant. Hence total transactions (T) and velocity of circulation of money (V+V1) also remain constant. Hence price (P) directly depends on quantity of money (M+M1).

Criticism: The quantity Theory of Money has been criticized by many economists on the following grounds.

1. This is based on the assumption of full employment. In less than full employment situation, when the quantity of money increases, price may or may not rise. Under this circumstance, when the quantity of money increases, investment will also increase. This will increase the supply of goods. Thus when demand and supply increases to the same extent, price may or may not rise.

This can be shown in the following diagram.
In this diagram D is the demand curve and S is the supply curve. T is the equilibrium position. So OP is the equilibrium price. As demand and supply increases, the new demand curve is D1 and the new supply curve is S1. T1 is the new equilibrium position. The price does not change, and remains at OP. So we can conclude that the Quantity Theory of Money comes to its own only when there is full employment situation.

2. According to the theory it is the quantity of money that determines the price. But according to the critics, in many circumstances such as war, inflation etc. it is the price that determines the quantity of money. In other words, price is not always determined by the quantity of money.

Friday, April 1, 2011

Money - An Economic Overview

Evolution of Money: The fundamental aim of man is to satisfy his economic wants. In earlier days man produced whatever was needed by him. But in course of time, economic wants started to increase. So to satisfy all his economic wants, man started to exchange the goods. In earlier days the system that was followed for exchange is known as the Barter System. Under this system there was direct exchange of goods for goods. But man started to face many difficulties under this system. So to overcome these difficulties man introduced money.

First precious metals were used as money. Then, in course of time, a small quantity of a metal, with a with a stamp or mark put on it to indicate value, was introduced to serve the purpose of money. This process is called coinage. Now a days paper money, duly sanctioned by law, with appropriate signs and symbols, is used used universally as the medium of exchange. For small transactions, however, coins are still used.

Legal Tender Money: Legal tender money means money, the tender or payment of which constitutes, by law, the sufficient discharge of a debt.

The fundamental difference between money and other commodities is that money is generally acceptable in payment for goods, services, debts and compensations, while other commodities are not. People want other commodities for the commodity's sake - to consume, enjoy or otherwise utilize them, but money is wanted not for its own sake but because it has purchasing power over other goods.

The real significance of money is that it is a claim, which can be used by its owner to buy everything. As because general acceptability is the fundamental characteristic of money, we can define money as anything which is generally accepted by people in exchange for commodities or services, or in payment of debts or compensations.

Mr. Paul Samuelson: "Money is an artificial social convention."

Definition: Money is something, which serves as a medium of exchange. It is accepted unquestionably by everyone in exchange for goods and services. Different economists have defined money in different ways. According to Mr. Francis Walker "money is what money does."

We can define money as anything, which is accepted by the people

1. as medium of exchange,
2. as a measurement of value,
3. as a store of value,
4. as a standard of deferred value, and
5. as a transfer of value.

From this above definition follows the functions of money.

1. Medium of Exchange: Money promotes or facilitates exchange of goods and services. Our whole economic system depends entirely upon money, without which all modern forms of consumption, production, distribution and exchange will cease to exist.

2. Measurement of Value: Money assigns a value or price to any commodity or service. Every commodity or service can be weighed in terms of money. So it serves as a measuring instrument for value.

3. Store of Value: Money is the best form in which one can store his wealth. It has a universal usefulness at any given time, which makes it the best form as a store of value.

4. Standard of Deferred Value: Money serves as standard for deferred payments, that is payments, which are to be made in future.

5. Transfer of Value: Since any economic commodity or service can be weighed in terms of money, for any kind of value transfer it acts as the best medium.

Demand for money or reasons for holding money: J, M. Keynes forwarded three primary reasons or motives for holding money.

1. Transactions motive: Every man requires a certain amount of money to meet his daily expenditure. From this, the transaction demand for money arises.
2. Precautionary motive: People normally hold more money than what is required for his transactions purpose. He keeps some extra money in hand to meet the unforeseen circumstances, or any kind of emergency situation. This gives birth to the precautionary demand for money.
3. Speculative motive: Money, when invested, brings income in the form of interest. If someone decides to hold money he will be foregoing the interest that it would have yielded, if invested. Thus holding money means preferring liquidity, as money is the most liquid form of asset. When there is an expectation that interest will rise in the future, people purchase securities to earn higher interest income in the future. Interest is the reward for parting with liquidity. Thus individuals or institutions, who have sufficient money left after satisfying the first two demands, may also need some money for speculative purpose.

In the short run, transactions demand and precautionary demand are more or less fixed. Only under a situation of rising prices and consequent inflation, these two demands may increase in the short run. Otherwise in the short run, it is the speculatory demand for money, which determines the overall demand for money.

Supply of Money: The supply of money basically means the quantity of money in circulation. In simple terms, the total amount of cash held by individuals and institutions in the form of notes and coins, together with the total value of deposits held in bank accounts of commercial banks, together with bills and bank notes constitute the supply of money. Some writers prefer to use the term money in a narrow sense to mean only legal tender money. Others include deposits, but only such deposits as are withdrawable by cheques, thus excluding non-chequeable deposits. The measures that are taken to control the total supply of money in an economy are compositely called the Monetary Policy.

Value of money: Meaning: Value of money means the purchasing power of money. It means that goods and services can be purchased with money. When more goods and services can be purchased with money, the value of money is said to be more, and vice versa.

Determination of the value of money: There are two theories given by the economists for the determination of the value of money. The two theories are

1) Quantity Theory of Money
2) Income Theory of Money
Update(s):Post(s) under preparation: -
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