MONETARY ECONOMIC

Unit I (Money & Banking)

Money: Money is defined as the mean of exchange between individuals. In a capitalist economy, this is a too simple definition. The fundamental purpose of money is a way to distribute the ownership in the society. Money is also used as a mean of exchange. Functions of Money: 1. Money as a Medium of Exchange 2. Money as Measure of Value 3. Standard of Deferred Payment 4. Money as a Store of Value. Fixed Fiduciary system: This is based on currency principle. According to this system, the central bank can issue notes up to a certain limit fixed by the Government without gold backing. The remaining notes are backed by Government, securities and bonds and if at any time the Central bank wants to issue more notes then, it should be backed by 100% gold reserve. In other words that Central bank can issue notes up to same limit against Government, security and excess of amount should be backed by 100% metallic reserve. Proportional reserve system: According to this system, a portion of the note issued is backed by metallic reserve and rest of the amount is backed by Government, securities and bonds. In other words central bank issued currency notes from 25% to 40% of which is backed by gold and the rest of 75% or 60% is backed by government, securities. Demand pull inflation: The most important inflation is called demand-pull or excess demand inflation. It occurs when the total demand for goods and services in an economy exceeds the available supply, so the prices for them rise in a market economy. There are a variety of possible reasons for the increased aggregate demand. Aggregate demand is made up of all spending in the economy. Causes of increase in costs: 1. Wages 2. Profits 3. Imported inflation 4. Exhaustion of natural resources 5. Taxes. Classical Theory of inflation :.Inflation occurs when the quantity of money increases and

thus by stabilising the quantity of money it could be checked by the monetary authorities. The quantity theory of money is, however, defective in the sense that it fails to explain the process whereby an increase in money supply results in an increased money spending at a time when flow of goods remains constant, and thus, bids up prices. Keynesian approach to inflation :Keyness analysis of inflation is in terms of excess demand. Keynes did not believe that there is a close tie between the quantity of money and the level of aggregate demand. In his opinion, an economy might experience some inflation with constant supply of money. He argued, let quantity of money remain unchanged when there is a rise in the general price level .
Stagflation: Stagflation is a term which is formed by joining the words stagnation and inflation. It is a newly developed term which is used in modern macroeconomics to give a description of a period of uncontrollable price inflation combined with sluggish output growth. Stagflation is a period of sluggish economic growth (stagnation) and rise of price (inflation). Stagflation raises unemployment. Types of theories of stagflation: i) Differential accumulation ii) Neo-classical theory iii) Shock theory iv) Quality of money theories v) Quantity theories of stagflation vi) Classical Keynesian Theory and the Phillips curve vii) Neo-Keynesian Theory. Commercial banks: Commercial banks are a part of organised money market. They perform all the activities of a typical bank. Commercial banks collect mobile savings from urban and rural areas and make it available to large, medium and small undertakings for their capital requirements.

Classification of Commercial banks: i) Public Sector banks ii) Private Sector Banks iii) Private Sector Indian Banks iv) Scheduled banks v) Non Scheduled banks Primary functions: (a) Acceptance of deposits from public (b) Lending of funds (c) Creation of Credit (d) Remittance of funds. Secondary Functions: a) Purchase and sale of Securities b) Acting as trustees, executors, administrators c) Payment and Collection of Subscription, dividend, salaries, pension etc d) Acting as Attorney e) Travelers cheques f) Merchant Banking g) Safe custody of Valuables h) Credit Cards i) Tax Consultancy j) Underwriting of securities k) Housing finance l) Factoring. Liquidity: Liquidity means the ability of the banker to produce cash on demand. As and when the bank receives deposits, it intends to invest them on assets. Whenever there is a demand for cash, the bank must be in a position to sell the asset without any loss to meet the claims of depositors. Profitability: Profitability is the second important objective of a commercial bank. Commercial bank is a business institution which aims at maximizing profits. The commercial bank is very much concerned with making as high a profit as possible. In acquiring money, the sole consideration of a commercial bank is to earn an income. Principle of Productivity: The objective of the bank is to earn maximum profits and its income must be acquired from productive investments. If the assets are productive, the income to the bank will also be stable. Principle of Diversity: The principle of diversity implies that investible funds should be invested in a diversified manner. It means that funds should be provided for all types of activities. According to this principle, the banks should as far as possible invest its surplus funds in different types of securities and in different types of business enterprises. Principle of Sale ability of Securities: This principle maintains that the bank should invest in those securities which could be easily sold in the money market. If a bank invests in unsalable securities, it may have to suffer from several losses. Hence it is very much desirable for the bank to invest in government or first class securities or in debentures of well-reputed firms. The functions of RBI: (i) Monopoly of Note Issue (ii) Bankers Bank and Lender of the last resort (iii) Banker to Government (iv) Controller of Credit (v) RBI as a bank of clearance. Bank Rate: Bank Rate can be defined as the standard rate at which the bank is prepared to buy or discount bills of exchange or other commercial papers eligible for purchases. Bank rate acts as a pace setter to other market rate of interest. Open Market Operation: Open market operations refers to buying and selling of government securities by the RBI in the money market to change the volume of money in circulation. The basic objective of this measure is to control the credit. Selective or qualitative credit controls: Selective or qualitative credit controls are those controls which regulates the uses to which credit is granted. The main qualitative credit control weapons are: (i) Fixation of margin requirements on secured loans (ii) Regulation of consumer credit. (iii) Control of bank advance through directives (iv) Rationing of credit. Rationing of credit: Rationing of credit is a system under which the central bank seeks to limit the total amount of loans and advances or specific categories of loans and advances granted by commercial banks. Moral Suasion: It is persuasive action by the central bank to the commercial banks to follow the general monetary policy of central bank. By taking big banks into confidence, central bank implements its policies. Small banks have no other alternative to follow big banks.

Direct Action: The activities of individual banks are dealt and studied separately. If the central bank thinks that there is a need for stronger action, it may take direct action against that particular bank by imposing punishment like higher interest on borrowings, out right stoppage of credit accommodation, delicensing of the bank and even liquidation.

Cambridge equation: Cambridge equation the equation which shows that the stock of money
multiplied by its velocity of circulation equals the average price level times the number of goods sold. This shows that a stable relationship exists between the stock of money and the national income. Different deposits provided by Commercial Banks: (i) Current account (ii) Savings account (iii) Fixed Deposit account.

Forms of advances given by commercial banks: 1. Loans 2. Overdraft 3. Cash credit

4. Bill Discounting

Open market operation: Open market operations are the means of implementing monetary
policy by which a central bank controls its national money supply by buying and selling government securities, or other instruments.

Unit II (Theory of Income & Employment)

Effective demand: Effective demand is an economic principle that suggests consumer needs and desires must be accompanied by purchasing power (money) to be considered effective in discussions of supply and demand for the determination of price. Effective Gross Income: Effective Gross Income (EGI) is one of the income figures that investors evaluating an income-producing property need to calculate as an intermediate step for estimating Net Operating Income (NOI) one of the most important measures of the income earning capacity of a property. Employment: Employment is a contract between two parties, one being the employer and the other being the employee. An employee may be defined as: A person in the service of another under any contract of hire, express or implied, oral or written, where the employer has the power or right to control and direct the employee in the material details of how the work is to be performed. Consumption function: Consumption function is a single mathematical function used to express consumer spending. It was developed by John Maynard Keynes and detailed most famously in his book The General Theory of Employment, Interest, and Money. The function is used to calculate the amount of total consumption in an economy. It is made up of autonomous consumption that is not influenced by current income and induced consumption that is influenced by the economys income level. Marginal propensity to consume: Marginal propensity to consume (MPC) is an empirical metric that quantifies induced consumption, the concept that the increase in personal consumer spending (consumption) that occurs with an increase in disposable income (income after taxes and transfers). For example, if a household earns one extra dollar of disposable income, and the marginal propensity to consume is 0.65, then of that dollar, the household will spend 65 cents and save 35 cents. Investment Multiplier: Investment Multiplier is the changes in income for changes in the investment. The concept o Multiplier was developed by Kahn. With change in the investment here will be a change in the income, because the investment expenditure turns into income. There after the income induce the consumption to increase depending on the level of marginal propensity of consumption. Investment function: The investment function is a summary of the variables that influence the levels of aggregate investments. It can be formalized as follows: I=I(r,Y,q)

The effects of Investment function: 1. It contributes to current demand of capital goods, thus it increases domestic expenditure; 2. It enlarges the production base (installed capital), increasing production capacity; 3. It modernizes production processes, improving cost effectiveness; 4. It reduces the labour needs per unit of output, thus potentially producing higher productivity and lower employment; 5. It allows for the production of new and improved products, increasing value added in production; 6. It incorporates international world-class innovations and quality standards, bringing the gap with more advanced countries and helping exports and an active participation to international trade.

Unit III (International Trade and Foreign Exchange)

International Trade: International trade refers to the process of buying and selling functions across the various countries. Characteristics of International business: (i) Accurate information (ii) Timely information (iii) Size of the business (iv) Market Segmentation (vi) Wider scope (vii) Intercountry Comparative Study. Reasons for going international: a) Profit advantage b) Domestic demand constraints c) Competition d) Govt. policies and regulations e) Availability of Human resources at less cost f) Nearness to raw materials g) High cost of transportation h) Monopoly power i) Availability of technology and managerial competence j) Liberalization and globalization k) Political stability v/s political instability.

Approaches of international business: 1) E - Ethnocentric approach

2) P - Polycentric

approach 3) R - Regiocentric approach 4) G - Geocentric approach Enthnocentric approach: According to this approach, overseas operations are viewed as secondary to domestic operations and primarily as a means of disposing of surplus domestic production. Polycentric approach: Under this approach, the company establishes a foreign subsidiary company in overseas market and operates independently of the others. Regiocentric approach: A regiocentric company views different regions as different markets. That is, markets with unique characteristics, are regarded as a single market. Geocentric approach: A Geocentric company views the entire world as a single market. Geocentrism is viewed as entailing high costs in collecting information and administering policies in a world-wide scale. In this respect, its opped is generally viewed as more economical and manageable.

Problems of International business: 1) Political factors 2) Huge foreign indebtedness 3) High

cost 4) Corruption 5) Technological pirating 6) Bureaucratic practices of government 7) Exchange instability 8) Entry requirements. Theory of Absolute Cost Advantage: (by Adam Smith): Every country should specialize and exchange these products with other products produced cheaply by other countries in producing those products that it can produce at less than that of other countries, as a result the other country has an absolute cost advantage over the first country in producing any other product. Comparative Cost Advantage with Money: According to this theory, comparative differences in labour cost of commodities can be translated into absolute differences in prices, without effecting the red exchange relations between products. Theory of Factor Endowment (Hecksetter-Ohlin thesis): According to this theory, a country will specialise in the production and export of those goods whose ratio between capital and other factors of production is higher then those in other countries. Factors to be considered while making decisions to enter foreign markets includes: Ownership advantage (b) Location advantage and (c) Internationalization advantage (a)

Ownership advantage : Ownership advantage refers to those advantages that the company can avail of by owning resources. It provides competitive edge over its competitors, to the domestic companies. These advantages may be tangible or intangible or both E.g. Tata Iron and Steel company (TISCO) have the advantage of low cost of production, as they are owning iron ore mines and coal mines. Location advantage: While deciding to go for overseas, the advantage of locational factors should be considered in the host country that are not available in the home country. It is because, if the company has all its locational advantages of factors like cheap labour, cheap raw material, good/favorable climatic conditions, availability of land at cheaper rates, political stability etc., in the home country itself it decides to enter overseas through exports. On the other hand, if the above said locational advantages are available at foreign countries it enters overseas market through direct investment. International advantage: If the company can manufacture goods or render services in the host country without any arrangements with the companies in the host country through contracts then it is said to have International benefit. Free Trade Agreements: Free Trade Agreements (FTAs) are generally made between two countries. Many governments, throughout the world have either signed FTA, or are negotiating or contemplating new bilateral free trade and investment agreements. Claiming Preferential Treatment: A claim for preferential treatment is usually made at the time of importation on the customs document used by the importing country. The Agreement allows NAFTA claims up to one year from the date of importation. The procedures for presenting a NAFTA claim are different in Canada, Mexico, and the United States. Merits of free trade: 1. Increased production 2. Production efficiencies 3. Benefits to consumers 4. Foreign exchange gains 5. Employment 6. Economic growth. Demerits of free trade: i) With the removal of trade barriers, structural unemployment may occur in the short term. ii) Increased domestic economic instability from international trade cycles, as economies become dependent on global markets. iii) International markets are not a level playing field as countries with surplus products may dump them on world markets at below cost. iv) Developing or new industries may find it difficult to become established in a competitive environment with no shortterm protection policies by governments, according to the infant industries argument. Balance of Payment: The balance of payments for a given period is defined as a systematic record of all economic transactions during the period between residents of the reporting country. It is a statistical record in the form of a balance sheet. It comprises of all the transactions of a country with the rest of the world during any given period. Adverse Balance of Payment: Adverse Balance of Payment refers to a situation wherein demand for foreign exchange exceeds its supply. Monetary Measures: a) Deflation b) Exchange Depreciation c) Devaluation d) Exchange control. Non - Monetary measures: substitution. a) Import duties b) Import quotas c) Export promotion d) Import

Fixed exchange rate systems: The fixed exchange rate system agree to keep their currencies
at a fixed, pegged rate and to change their value only at fairly infrequent intervals, when the economic situation forces them to do so. Flexible Exchange Rate System: Under the flexible exchange rate system, exchange rates are freely determined in an open market, primarily by private dealings and they like market prices vary from day -to-day. In other words, these rates are determined by market forces like demand for and supply of foreign exchange. Theory of comparative cost advantage: According to this theory It is common that some countries have the advantage of producing same goods at a lower cost compared to others

because of availability of cheap labour, skilled labour, cheap raw material, good climatic conditions etc. Balance of payments: Balance of payments statement is drawn up in terms of debits and credits based on a system of double-entry book-keeping. The term balance of payments is used to denote the record of economic transactions between one country and another. It is a statistical record in the form of a balance sheet. It comprises of all its transactions with the rest of the world during any given period.

Participants of FOREX market: (i) Retail customers (ii) Foreign Exchange Dealers (iii)
Foreign Exchange broker (iv) Central Banks. Exchange rate: Exchange rate is the price paid in the home currency for a unit of foreign currency. Various concepts of foreign exchange rates are: a. Cross Rate ask spread d. Forward Exchange rates. b. Spot exchange Rate c. Bid

Factors which influence the foreign exchange rate: (i) Fundamental factors (ii) Technical
factors (iii) Market based factors. Floating rate system: Under the floating rate system, exchange rates are freely determined in an open market, primarily by private dealing and they like market prices vary from day-to-day. It is simple to operate and adjustments of exchange rate under this system, is a continuous process. This system does not result in deficit/surplus of foreign exchange. The exchange rate moves automatically and freely. Kinds of exposures: (i) Economic exposure (ii) Transaction exposure (iii) Translation exposure. Common foreign exchange controls include: i) Banning the use of foreign currency within the country ii) Banning locals from possessing foreign currency iii) Restricting currency exchange to government-approved exchangers iv) Fixed exchange rates v) Restrictions on the amount of currency that may be imported or exported.

Unit IV (Public Finance)

Public finance: Public finance is a field of economics concerned with paying for collective or governmental activities, and with the administration and design of those activities. The field is often divided into questions of what the government or collective organizations should do or are doing, and questions of how to pay for those activities. The importance of public finance: 1. Public Finance Management 2. Government expenditures 3. Government operations. Cannons of taxation: Cannons of taxation refer to the principles or rules laid down by economists and statesmen for guiding the taxing authority. Cannon of ability or equity: According to this cannon, the tax imposed on the tax payers must be proportional to the ability to pay tax. Cannon of economy: This cannon implies that the cost of collecting taxes must be minimum, so that the net tax revenue will be higher. Canon of convenience: This canon signifies that the tax payer must be permitted to pay the tax at times convenient to them. Canon of certainty: This canon implies that the tax payer must be certain about the taxes to be paid and also the mode of payment. Cannon of productivity: According to this concept, the taxes imposed must not affect production and distribution of the counting adversely. Canon of elasticity: This cannon means that the taxes must be elastic i.e. slight changes in the rates of tax must lead to more increase in the amount of tax revenues.

Canon of flexibility: This canon signifies that the taxes should be capable of being adjusted according to situation. Canon of diversity: This canon means that the tax structure must be broad based. Canon of simplicity: This canon signifies that the tax rules and procedure must be so simple that the tax payer will be able to understand the details of taxes easily. Public debt: Public debt is one result of government financing expenditures. It is different from private debt, which consists of the obligations of individuals, businesses, and nongovernmental organizations. Public debt comes about as a result of taxing and borrowing by the federal government. Types of Debt: 1) Secured and unsecured debt, 2) Private and public debt, 3) Syndicated and bilateral debt, and 4) Other types of debt that display one or more of the characteristics noted above. Secured and unsecured debt: A debt obligation is considered secured if creditors have recourse to the assets of the company on a proprietary basis or otherwise ahead of general claims against the company. Unsecured debt comprises financial obligations, where creditors do not have recourse to the assets of the borrower to satisfy their claims. Private and public debt: Private debt comprises bank-loan type obligations, whether senior or mezzanine. Public debt is a general definition covering all financial instruments that are freely trade able on a public exchange or over the counter, with few if any restrictions. Syndicated and bilateral debt: A syndicated loan is a loan that is granted to companies that wish to borrow more money than any single lender is prepared to risk in a single loan, usually many millions of Rupees. In such a case, a syndicate of banks can each agree to put forward a portion of the principal sum. Other types of debt: Loans which are extended by a bilateral creditor are called as bilateral debt. A basic loan is the simplest form of debt. It consists of an agreement to lend a principal sum for a fixed period of time, to be repaid by a certain date. In commercial loans interest, calculated as a percentage of the principal sum per year, will also have to be paid by that date. Proportional: Proportional which constituting a proportion and having the same, or a constant, ratio; as, proportional quantities; momentum is proportional to quantity of matter. Progressive taxation system: A progressive tax is a tax by which the tax rate increases as the taxable base amount increases. Progressive describes a distribution effect on income or expenditure, referring to the way the rate progresses from low to high, where the average tax rate is less than the marginal tax rate. Regressive taxation system: A regressive tax is a tax imposed in such a manner that the tax rate decreases as the amount subject to taxation increases. Regressive describes a distribution effect on income or expenditure, referring to the way the rate progresses from high to low, where the average tax rate exceeds the marginal tax rate. Expenditures for Fulfilling the Protective Functions of the State: Of the general class of expenditures incurred in fulfilling the protective function of the State, the first to be mentioned are those (a) for security from foes without the State Expenditures for Internal Security: Under expenditures for internal security are included the cost of our police system in all its branches, including constables, sheriffs, etc., and that of our judiciary system, since both of these are occupied almost wholly in securing persons and property from injury. Expenditures for the Poor and Unfortunate: Every civilized government recognizes an obligation to extend relief to paupers, to the deaf, the blind, the insane, and the feeble-minded, who, from natural defects, are unable to hold their own in the struggle for existence. Expenditures for Fulfilling the Commercial Functions: A second general class of expenditures consists of those which are incurred in fulfilling the commercial functions of the State.

Expenditures for Fulfilling the Developmental Function: The third general class of expenditures consists of those incurred in fulfilling the developmental function of the State. Most important among these is (a) the expenditure for education. Of all classes of expenditure that for education has grown most constantly and rapidly in the modern State. Especially has such expenditure increased with the spread of democracy in government. Expenditures for the Maintenance of Government: The expenditures we have been considering are, of course, expenditures by government: we have now to mention a fourth general class, the expenditures for government; that is, expenditures for governmental functions too general and fundamental to be ranged under any of the heads that we have before mentioned. Such are the expenditures for (a) legislation and administration, and for (6) tax collection. The effects of increase public expenditure: 1. Consumption Production 4. Distribution 5. Economic Stabilization. 2. Allocation of Resources 3.

Public Finance: Public Finance is that part of finance which is around the central question of
allocation of resources subjected to the budget constraint of the government or public entities. It is that branch of economics which identifies and appraises the means and effects of the policies of the government. Objectives of taxation: (i) Raising Revenue (ii) Regulation of Production and consumption (iii) Economic Development (iv) Reduction of Unemployment (v) Reduction of Regional imbalances (vi) Capital accumulation (vii) Better distribution of Income and Wealth (viii) Reduce the effect of depression and inflation. Taxable capacity: Taxable capacity is defined as the maximum amount which the citizen of a country can contribute towards the expenses of public authorities without having to undergo an unbearable strain. Employment: Employment is a contract between two parties, one being the employer and the other being the employee. An employee may be defined as: A person in the service of another under any contract of hire, express or implied, oral or written, where the employer has the power or right to control and direct the employee in the material details of how the work is to be performed. Ending employment: An offer of employment, however, does not guarantee employment for any length of time and each party may terminate the relationship at any time. This is referred to as at-will employment. In some professions it is customary to offer two weeks notice when resigning for a job, but that may not be legally enforceable. Distribution: Distribution is all the organisations through which a product must pass between its point of production and consumption. Distribution is one of the four elements of the marketing mix. An organization or set of organizations involved in the process of making a product or service available for use or consumption by a consumer or business user. The principles of public expenditures: i) Comprehensiveness ii) Discipline iii) Legitimacy iv) Flexibility v) Predictability vi) Contestability vii) Honesty viii) Information ix) Transparency x) Accountability.