CHAPTER-2

VALUE OF MONEY
What is value of money?

Value of money is the quantity of goods in general that will be exchanged for one unit of money.
The value of money is its purchasing power, i.e., the quantity of goods and services it can
purchase.

What money can buy depends on the level of prices. When the price level rises, a unit of money
can purchase less goods than before. Money is then said to have depreciated. Conversely, a fall
in prices signifies that a unit of money can buy more than before.

What is index number?

An index number is a statement in the form of a table which represents a change in the general price level.

Index number is a technique of measuring changes in a variable or group of variables with respect to time,
geographical location or other characteristics

Methods of preparing price index numbers

(a) Selection of the Base Year:

The first thing necessary is to select a base year. It is the year with which we wish to compare the
present prices, in order to see how much the prices have risen or fallen. The base year must be a
normal year. It should not be a year of famine, or war, or a year of exceptional prosperity.

(b) Selection of Commodities:

The next step is to select the commodities to be included in the index number. The commodities
will depend on the purpose for which the index number is prepared. Suppose we want to know
how a particular class of people has been affected by a change in the general price level. In that
case, we should include only those commodities which enter into the consumption of that class.

(c) Collection of Prices:

After commodities have been selected, their prices have to be ascertained. Retail prices are the
best for the purpose, because it is at the retail prices that a commodity is actually consumed. But
retail prices differ almost from shop to shop, and there is no proper record of them.

(d) Finding Percentage Change:

The next step is to represent the present prices as the percentages of the base year prices. The
base year price is equated to 100, and then the current year’s price is represented accordingly.
This will be clear from the index number given on the next page.

(e) Averaging.

Finally, we take the average of both the base year and the current year figures in order to find out
the overall change. In May 1985, the price index was 355 which means that the price on the
average were more than three-and a-half times as much or 255 per cent higher than what they
were in 1970-71.

What are the difficulties in the construction of price index numbers?

Measurement of changes in the value of money through price index number is not an easy and
reliable technique. There are a number of theoretical as well as practical difficulties in the
construction of price index numbers. Moreover, the index number technique itself has many
limitations.

(A) Conceptual Difficulties:

1. Vague Concept of Value of Money:

The concept of money is vague, abstract and cannot be clearly defined. The value of money is a
relative concept which changes from person to person depending upon the type of goods on
which the money is spent.

2. Inaccurate Measurement:

Price index numbers do not measure the changes in the value of money accurately and reliably.
A rise or fall in the general level of prices as indicated by the price index numbers does not mean
that the price of every commodity has risen or fallen to the same extent.

3. Reflect General Changes:

Price index numbers are averages and measure general changes in the value of money on the
average. Therefore, they are not of much significance for the particular individuals who may be
affected by the changes in the actual prices quite differently from that indicated by the index
numbers.

4. Limitations of Wholesale Price Index:

The wholesale price index numbers, which are generally used to measure changes in the value of
money, suffer from certain limitations:

(a) They do not reflect the changes in the cost of living because retail prices are generally higher
than the wholesale prices.
(b) They ignore some of the important items concerning the urban population, such as,
expenditure on education, transport, house rent, etc.

(c) They do not take into consideration the changes in the consumers’ preferences.

(B) Practical Difficulties:

1. Selection of Base Year:

While preparing the index number, first difficulty arises regarding the selection of base year. The
base year should be a normal year. But, it is very difficult to find out a fully normal year free
from any unusual happening. There is every possibility that the selected base year may be an
abnormal year, or a distant year, or may be selected by an immature or biased person.

2. Selection of Items:

(a) With the passage of time the quality of the product may change ; if the quality of a product
changes in the year of enquiry from what it was in the base year, the product becomes irrelevant,

(b) The relative importance of certain commodities may change due to a change in the
consumption pattern of the people in the course of time; for example, Vanaspati Ghee was not an
important item of consumption in India in the pre-war period, but today it has become an item of
necessity..

3. Collection of Prices:

It is also difficult to obtain correct, adequate and representative data regarding prices. It is not an
easy job to select representative places from which the information about prices to be collected
and to select the experienced and unbiased individuals or institutions who will supply price
quotations. Moreover, there is the problem of deciding which prices (wholesale or retail) are to
be taken into consideration.

4. Assigning Weights:

Another important difficulty that arises in preparing the index numbers is that of assigning
proper weights to different items in order to arrive at correct and unbiased conclusions. As there
are no hard and fast rules to weights for the commodities according to their relative importance,
there is very likelihood that the weights are decided arbitrarily on the basis of personal judgment
and involve biasness.

5. Selection of Averages:

Another major problem is that which average should be employed to find out the price relatives.
There are many types of averages such as arithmetic average, geometric average, mean, median,
mode, etc. The use of different averages gives different results. Therefore, it is essential to select
the method with great care.
6. Problem of Dynamic Changes:

In the dynamic world, the consumption pattern of the individuals and the number and varieties of
goods undergo continuous changes.

Types of price index numbers

1. Wholesale Price Index Numbers:

Wholesale price index numbers are constructed on the basis of the wholesale prices of certain
important commodities. The commodities included in preparing these index numbers are mainly
raw-materials and semi-finished goods. Only the most important and most price-sensitive and
semi- finished goods which are bought and sold in the wholesale market are selected and weights

2. Retail Price Index Numbers:

These index numbers are prepared to measure the changes.in the value of money on the basis of
the retail prices of final consumption goods. The main difficulty with this index number is that
the retail price for the same goods and for continuous periods is not available. The retail prices
represent larger and more frequent fluctuations as compared to the wholesale prices.

3. Cost-of-Living Index Numbers:

These index numbers are constructed with reference to the important goods and services which
are consumed by common people. Since the number of these goods and services is very large,
only representative items which form the consumption pattern of the people are included. These
index numbers are used to measure changes in the cost of living of the general public.

4. Working Class Cost-of-Living Index Numbers:

The working class cost-of-living index numbers aim at measuring changes in the cost of living of
workers. These index numbers are consumed on the basis of only those goods and services which
are generally consumed by the working class. The prices of these goods and index numbers are
of great importance to the workers because their wages are adjusted according to these indices.

5. Wage Index Numbers:

The purpose of these index numbers is to measure time to time changes in money wages. These
index numbers, when compared with the working class cost-of-living index numbers, provide
information regarding the changes in the real wages of the workers.

6. Industrial Index Numbers:

Industrial index numbers are constructed with an objective of measuring changes in the industrial
production. The production data of various industries are included in preparing these index
numbers.
The purpose of these index numbers is to measure time to time changes in money wages. These
index numbers, when compared with the working class cost-of-living index numbers, provide
information regarding the changes in the real wages of the workers.

6. Industrial Index Numbers:

Industrial index numbers are constructed with an objective of measuring changes in the industrial
production. The production data of various industries are included in preparing these index
numbers.

Importance of price index numbers

1. In Measuring Changes in the Value of Money:

Index numbers are used to measure changes in the value of money. A study of the rise or fall in

the value of money is essential for determining the direction of production and employment to

facilitate future payments and to know changes in the real income of different groups of people

at different places and times. As pointed out by Crowther, “By using the technical device of an

index number, it is thus possible to measure changes in different aspects of the value of money,

each particular aspect being relevant to a different purpose.”

2. In Cost of Living:

Cost of living index numbers in the case of different groups of workers throw light on the rise or

fall in the real income of workers. It is on the basis of the study of the cost of living index that

money wages are determined and dearness and other allowances are granted to workers. The cost

of living index is also the basis of wage negotiations and wage contracts.

3. In Analysing Markets for Goods and Services:

Consumer price index numbers are used in analysing markets for particular kinds of goods and

services. The weights assigned to different commodities like food, clothing, fuel, and lighting,

house rent, etc., govern the market for such goods and services.
4. In Measuring Changes in Industrial Production:

Index numbers of industrial production measure increase or decrease in industrial production in a

given year as compared to the base year. We can know from such as index number the actual

condition of different industries, whether production is increasing or decreasing in them, for an

industrial index number measures changes in the quantity of production.

5. In Internal Trade:

The study of indices of the wholesale prices of consumer and industrial goods and of industrial

production helps commerce and industry in expanding or decreasing internal trade.

6. In External Trade:

The foreign trade position of a country can be accessed on the basis of its export and import

indices. These indices reveal whether the external trade of the country is increasing or

decreasing.

7. In Economic Policies:

Index numbers are helpful to the state in formulating and adopting appropriate economic

policies. Index numbers measure changes in such magnitudes as prices, incomes, wages,

production, employment, products, exports, imports, etc. By comparing the index numbers of

these magnitudes for different periods, the government can know the present trend of economic

activity and accordingly adopt price policy, foreign trade policy and general economic policies.

8. In Determining the Foreign Exchange Rate:

Index numbers of wholesale price of two countries are used to determine their rate of foreign

exchange. They are the basis of the purchasing power parity theory which determines the

exchange rate between two countries on inconvertible paper standard.

Limitations of price index numbers

(a) Choice of a Base Year:

The first major problem is concerned with the choice of a base year. Two criteria for the
selection of’ base year are that it must show economic stability and it must not be too distant
from the given year. The base period must not coincide with abnormally high or low prices. But
it is very difficult to get a ‘normal year’ free from any economic disturbances.
(b) Problem of Averaging of Prices:
An index number is a summary measure. Thus, its usefulness decreases as it tries to describe a
complex situation which is too wide in scope.

The arithmetic mean or any other form of averages becomes less and less representative. Such
averaging is beset within certain technical difficulties. Some people recommend arithmetic mean
while others recommend geometric mean. Proper method of averaging is, thus, not obtainable.

(c) Difficulty of Obtaining Correct Data:

Data or statistics collected are often unreliable and less accurate. As a result, estimates based on
such data are bound to be unreliable.

(d) Difficulty in the Selection of Prices:

There are two prices—wholesale and retail. Should we select retail prices or wholesale prices?
General Price index is based on the wholesale prices which are easy to collect. But as far as
consumers are concerned, retail prices are more relevant.

(e) Difficulty in the Selection of Commodities and Choice of Weights:

The basket of goods and weights given to them are merely arbitrary. Basket of goods that are
chosen is based on current spending habits and incomes of consumers. Different classes of
people buy different kinds of goods. Therefore, it is difficult to choose all kinds of commodities.

Theories of value of money

1. Quantity Theory of Money: Fisher’s Transactions Approach:

The general level of prices is determined, that is, why at sometimes the general level of prices

rises and sometimes it declines. Sometime back it was believed by the economists that the

quantity of money in the economy is the prime cause of fluctuations in the price level.
The theory that increases in the quantity of money leads to the rise in the general price was

effectively put forward by Irving Fisher.’ They believed that the greater the quantity of money,

the higher the level of prices and vice versa.

Therefore, the theory which linked prices with the quantity of money came to be known as

quantity theory of money. In the following analysis we shall first critically examine the quantity

theory of money and then explain the modem view about the relationship between money and

prices and also the determination of general level of prices.

The quantity theory of money seeks to explain the value of money in terms of changes in its

quantity. Stated in its simplest form, the quantity theory of money says that the level of prices

varies directly with quantity of money. “Double the quantity of money, and other things being

equal, prices will be twice as high as before, and the value of money one-half. Halve the quantity

of money and, other things being equal, prices will be one-half of what they were before and the

value of money double.”

The theory can also be stated in these words: The price level rises proportionately with a given

increase in the quantity of money. Conversely, the price level falls proportionately with a given

decrease in the quantity of money, other things remaining the same.

There are several forces that determine the value of money and the general price level.

The general price level in a community is influenced by the following factors:

(a) The volume of trade or transactions;

(b) The quantity of money;

(c) Velocity of circulation of money.

The first factor, the volume of trade or transactions, depends upon the supply or amount of goods

and services to be exchanged. The greater the amount or supply of goods in an economy, the

larger the number of transactions and trade, and vice versa.

Fisher’s Equation of Exchange:

An American economist, Irving Fisher, expressed the relationship between the quantity of money

and the price level in the form of an equation, which is called ‘the equation of exchange’.

This is:

PT = MV….(1)

Or P = MV/T

Where P stands for the average price level:

T stands for total amount of transactions (or total trade or amount of goods and services, raw

materials, old goods etc.)

M stands for the quantity of money; and

V stands for the transactions velocity of circulation of money.

The equation (1) or (2) is an accounting identity and true by definition. This is, because MV

which represents money spent on transactions must be equal to Pr which represents money

received from transactions.

However, the equation of exchange as given in equations (1) and (2) has been converted into a

theory of determination of general level of prices by the classical economists by making some

assumptions. First, it has been assumed that the physical volume of transactions is constant

because it is determined by a given amount of real resources, the given level of technology and

the efficiency with which the given available resources are used.

These real factors determine a level of aggregate output which necessitates various types of

transactions. Another crucial assumption is that transactions velocity of circulation (V) is also

constant. The quantity theorists accordingly believed that velocity of circulation (V) depends on

the methods and practices of factor payments such as frequency of wage payments to the

workers, and habits of the people regarding spending their money incomes after they receive

them.

Further, velocity of circulation of money also depends on the development of banking and credit

system, that is, the ways and speed with which cheques are cleared, loans are granted and repaid.

According to them, these practices do not change in the short run.

This assumption is very crucial for the quantity theory of money because when the quantity of

money is increased this may cause a decline in velocity of circulation of money, then MV may

not change if the decline in V offsets the increase in M. As a result, increase in M will not affect

PY.

The quantity theorists believed that the volume of transactions (T) and the changes in it were

largely independent of the quantity of money. Further, according to them, changes in velocity of

circulation (VO and price level (P) do not cause any change in volume of transactions except

temporarily.
Thus classical economists who put forward the quantity theory of money believed that the

number of transactions (which ultimately depends on aggregate real output) does not depend on

other variables (M, V and P) in the equation of exchange. Thus we see that the assumption of

constant V and T converts the equation of exchange (MV = PT), which is an accounting identity,

into a theory of the determination of general price level.

Suppose the quantity of money is Rs. 5, 00,000 in an economy, the velocity of circulation of

money (V) is 5; and the total output to be transacted (T) is 2, 50,000 units, the average price

level (P) will be:

P = MV/T

= 5, 00,000 × 5/ 2, 50,000 = 2,500,000/ 2, 50,000

= Rs. 10 per unit.

If now, other things remaining the same, the quantity of money is doubled, i.e., increased to

Rs. 10, 00,000 then:

P = 10, 00,000 × 5/ 2, 50,000 = Rs. 20 per unit

We thus see that according to the quantity theory of money, price level varies in direct

proportion to the quantity of money. A doubling of the quantity of money (M) will lead to the

doubling of the price level. Further, since changes in the quantity of money are assumed to be

independent or autonomous of the price level, the changes in the quantity of money become the

cause of the changes in the price level.

2. Quantity Theory of Money: The Cambridge Cash Balance Approach:
The equation of exchange has been stated by Cambridge economists, Marshall and Pigou, in a

form different from Irving Fisher. Cambridge economists explained the determination of value of

money in line with the determination of value in general.

Value of a commodity is determined by demand for and supply of it and likewise, according to

them, the value of money (i.e., its purchasing power) is determined by the demand for and supply

of money. As studied in cash-balance approach to demand for money Cambridge economists laid

stress on the store of value function of money in sharp contrast to the medium of exchange

function of money emphasised by in Fisher’s transactions approach to demand for money.

According to cash balance approach, the public likes to hold a proportion of nominal income in

the form of money (i.e., cash balances). Let us call this proportion of nominal income that people

want to hold in money as k.

Then cash balance approach can be written as:

Md =kPY ….(1)

Y = real national income (i.e., aggregate output)

P = the price level PY = nominal national income

k = the proportion of nominal income that people want to hold in money

Md = the amount of money which public want to hold

Now, for the achievement of money-market equilibrium, demand for money must equal worth

the supply of money which we denote by M. It is important to note that the supply of money M
is exogenously given and is determined by the monetary policies of the central bank of a country.

Thus, for equilibrium in the money market.

M = Md

As Md =kPY

Therefore, in equilibrium M = kPY …(2)

P = 1/k.M/Y…………(3)

Like Fisher’s equation, cash balance equation is also an accounting identity because k is

defined as:

Quantity of Money Supply/National Income, that is, M/PY

Now, Cambridge economists also assumed that k remains constant. Further, due to their belief

that wage-price flexibility ensures full employment of resources, the level of real national

income was also fixed corresponding to the level of aggregate output produced by full

employment of resources.

Thus, from equation (3) it follows that with k and Y remaining constant price level (P) is deter-

mined by the quantity of money (M); changes in the quantity of money will cause proportionate

changes in the price level.

Some economists have pointed out similarity between Cambridge cash-balance approach and

Fisher’s transactions approach. According to them, k is reciprocal of V (k = 1/V or V = 1/k).

Thus in equation (2) if we replace k by , we have

M = 1/PY

Or MV=PY

Like Fisher’s approach, cash balance approach also assumes that full- employment of resources

will prevail due to the wage-price flexibility. Hence, it also believes the aggregate supply curve

as perfectly inelastic at full-employment level of output.

Criticism of fisher’s equation

1. Useless truism:

With the qualification that velocity of money (V) and the total output (T) remain the same, the

equation of exchange (MV= PT) is a useless truism. The real trouble is that these things seldom

remain the same. They change not only in the long run but also in a short period. Fisher’s

equation of exchange simply tells us that expenditure made on goods (MV) is equal to the value

of output of goods and services sold (PT).

2. Velocity of money is not stable:

Keynesian economists have challenged the assumption that velocity of money remains stable.

According to them, velocity of money changes inversely with the change in money supply. They

argue that increase in money supply, demand for money remaining constant, leads to the fall in

the rate of interest.

3. Increase in quantity of money may not always lead to the increase in aggregate spending

or demand:
Further, according to Keynes’ the quantity theory of money is based upon two more wrong

assumptions.

Basically, for, the quantity theory to be true, the following two assumptions must hold:

(i) An increase is money supply must lead to an increase in spending, that is, aggregate demand

i.e., no part of additional money created should be kept in idle hoards.

(ii) The resulting increase in spending or aggregate demand must face a totally inelastic output.

4. Assumption of constant volume of transactions or constant level of aggregate output is

not valid:

Keys asserted that the assumption of constant aggregate output valid only under conditions of

full employment. It is only then that we can assume a totally inelastic supply of output, for all the

available resources are being already fully utilised. In conditions of less than full employment,

the supply curve of output will be elastic.

Demand for money

What is demand for money?

in monetary economics, the demand for money is the desired holding of financial assets in the
form of money: that is, cash or bank deposits rather than investments.

It can refer to the demand for money narrowly defined as M1 (directly spendable holdings), or

for money in the broader sense of M2 or M3.

Three motives of demand for money (J. M Keynes)

1. Transaction motive
The transactions demand for money arises from the medium of exchange function of money in

making regular payments for goods and services. According to Keynes, it relates to “the need of

cash for the current transactions of personal and business exchange” It is further divided into

income and business motives. The income motive is meant “to bridge the interval between the

receipt of income and its disbursement.”

Similarly, the business motive is meant “to bridge the interval between the time of incurring

business costs and that of the receipt of the sale proceeds.” If the time between the incurring of

expenditure and receipt of income is small, less cash will be held by the people for current

transactions, and vice versa. There will, however, be changes in the transactions demand for

money depending upon the expectations of income recipients and businessmen. They depend

upon the level of income, the interest rate, the business turnover, the normal period between the

receipt and disbursement of income, etc.

2. Precautionary motive:

The Precautionary motive relates to “the desire to provide for contingencies requiring sudden

expenditures and for unforeseen opportunities of advantageous purchases.” Both individuals and

businessmen keep cash in reserve to meet unexpected needs. Individuals hold some cash to

provide for illness, accidents, unemployment and other unforeseen contingencies.

Similarly, businessmen keep cash in reserve to tide over unfavourable conditions or to gain from

unexpected deals. Therefore, “money held under the precautionary motive is rather like water

kept in reserve in a water tank.” The precautionary demand for money depends upon the level of

income, and business activity, opportunities for unexpected profitable deals, availability of cash,

the cost of holding liquid assets in bank reserves, etc.

Keynes held that the precautionary demand for money, like transactions demand, was a function

of the level of income. But the post-Keynesian economists believe that like transactions demand,

it is inversely related to high interest rates. The transactions and precautionary demand for

money will be unstable, particularly if the economy is not at full employment level and

transactions are, therefore, less than the maximum, and are liable to fluctuate up or down.

3.The Speculative Demand for Money:

The speculative (or asset or liquidity preference) demand for money is for securing profit from

knowing better than the market what the future will bring forth”. Individuals and businessmen

having funds, after keeping enough for transactions and precautionary purposes, like to make a

speculative gain by investing in bonds. Money held for speculative purposes is a liquid store of

value which can be invested at an opportune moment in interest-bearing bonds or securities.

Bond prices and the rate of interest are inversely related to each other. Low bond prices are

indicative of high interest rates, and high bond prices reflect low interest rates. A bond carries a

fixed rate of interest. For instance, if a bond of the value of Rs 100 carries 4 per cent interest and

the market rate of interest rises to 8 per cent, the value of this bond falls to Rs 50 in the market. If

the market rate of interest falls to 2 per cent, the value of the bond will rise to Rs 200 in the

market.
Supply of money

What is supply of money?

The total stock of money circulating in an economy is the money supply. The circulating money

involves the currency, printed notes, money in the deposit accounts and in the form of other

liquid assets.

Components of money supply

However, since 1977 RBI is publishing data on four alternative measures of money supply
denoted by M1, M2, M3and M4 as follows:
M or M1 = c + dd + od
M2 = M1 + Savings deposits with post office saving banks
(AMR) M3 = M1 + net time deposits of banks
M4 = M3 + total deposits with post office saving banks.

What is high powered money?

Monetary base. Sum of the currency held by the public and reserves held by financial

institutions with the Federal Reserve Banks. ... Also called High Powered Money because the

effect of changes in monetary base on money supply is magnified by the money multiplier.

Modern theory of money

Modern Quantity Theory of Money predicts that the demand for money should depend not only
on the risk and return offered by money but also on the various assets which the households can
hold instead of money.

The money demand should depend on the total wealth, the reason being wealth measures the size
of the portfolio to be allocated among money and the alternative assets.

Thus, Money demand function is essentially a function of wealth (W):

ADVERTISEMENTS:

Two alternative forms in which wealth can be held are:

(i) Bonds.

(ii) Equity (Shares).

... (M/P)d = L (rs, rb, ne, W) …(1)

ADVERTISEMENTS:

Where rs is the expected real return on stock rb is the expected real return on bonds
IT’ is the expected rate of inflation

W is real wealth.

M → nominal money demand

P → Price level

Equation (1) shows that Demand for money depends on return on bonds and equity. Inflation
affects the amount of wealth held.

Therefore, Md depends on return on bonds and equity. Inflation affects the amount of wealth
held.
If rs or rb increases, money demand reduces, because other assets become more attractive.
If FT increases, money demand reduces because money becomes less attractive.

ADVERTISEMENTS:

If W increases money demand increases because higher wealth means a larger portfolio.

For simplicity, equation 1 can be written as:

(M/P)d = L(Y, i) …(2)

Real income (Y) is used instead of W

i is the interest rate. It is the return variable which includes nominal interest rate.
= rb + Πe
This demand function of money equation (2) is very similar to that derived from the Keynesian
approach.

Limitation of the Portfolio theories:

The utility of portfolio theory in studying the demand for money depends on which measure of
money supply is used.

The portfolio theories of money demand are plausible only if we adopt a broad measure of
money supply (M2):
This is because:
M1 is the Narrow Measure of money as it includes only coins and currency with people and
demand deposits which earn very low or no interest rate.
M1 = Currency + Demand Deposits
Thus portfolio theories are useful only when we take (M2) measure of money supply because:
M2 = M1 + Saving accounts + money market mutual funds.