Monetary Policy and RBI

Instruments of Monetary Policy and the Reserve Bank of India

It is clear from the discussion in the previous blog that the total amount of money stock in the economy is much greater than the volume of high powered money. Commercial banks create this extra amount of money by giving out a part of their deposits as loans or investment credits. It is also evident that the total amount of deposits held by all commercial banks in the country is much larger than the total size of their reserves. If all the account-holders of all commercial banks in the country want their deposits back at the same time, the banks will not have enough means to satisfy the need of every accountholder and there will be bank failures. All this is common knowledge to every informed individual in the economy. Why do they still keep their money in bank deposits when they are aware of the possibility of default by their banks in case of a bank run (a situation where everybody wants to take money out of one’s bank account before the bank runs out of reserves)? The Reserve Bank of India plays a crucial role here. In case of a crisis like the above it stands by the commercial banks as a guarantor and extends loans to ensure the solvency of the latter. This system of guarantee assures individual account-holders that their banks will be able to pay their money back in case of a crisis and there is no need to panic thus avoiding bank runs. This role of the monetary authority is known as the lender of last resort.

Apart from acting as a banker to the commercial banks, RBI also acts as a banker to the Government of India, and also, to the state governments. It is commonly held that the government, sometimes, ‘prints money’ in case of a budget deficit, i.e., when it cannot meet its expenses (e.g. salaries to the government employees, purchase of defense equipment from a manufacturer of such goods etc.) from the tax revenue it has earned. The government, however, has no legal authority to issue currency in this fashion. So it borrows money by selling treasury bills or government securities to RBI, which issues currency to the government in return. The government then pays for its expenses with this money. The money thus ultimately comes into the hands of the general public (in the form of salary or sales proceeds of defense items etc.) and becomes a part of the money supply. Financing of budget deficits by the governments in this fashion is called Deficit Financing through Central Bank Borrowing. However, the most important role of RBI is as the controller of money supply and credit creation in the economy. RBI is the independent authority for conducting monetary policy in the best interests of the economy – it increases or decreases the supply of high powered money in the economy and creates incentives or disincentives for the commercial banks to give loans or credits to investors. The instruments which RBI uses for conducting monetary policy are as follows.


Open Market Operations:

RBI purchases (or sells) government securities to the general public in a bid to increase (or decrease) the stock of high powered money in the economy. Suppose RBI purchases Rs 100 worth government securities from the bond market. It will issue a cheque of Rs 100 on itself to the seller of the bond. The seller will deposit the cheque in her bank, which, in turn, will credit the seller’s account with a balance of Rs 100. The bank’s deposits go up by Rs 100 which is a liability to the bank. However, its assets also go up by Rs 100 by the possession of this cheque, which is a claim on RBI. The bank will deposit this cheque to RBI which, in turn, will credit the bank’s account with RBI with Rs 100.

Total liability of RBI, or, by definition, the supply of high powered money in the economy has gone up by Rs 100. If RBI wishes to reduce the supply of high powered money it undertakes an open market sale of government securities of its own holding in just the reverse fashion, thereby reducing the monetary base.


Bank Rate Policy:

As mentioned earlier, RBI can affect the reserve deposit ratio of commercial banks by adjusting the value of the bank rate – which is the rate of interest commercial banks have to pay RBI – if they borrow money from it in case of shortage of reserves. A low (or high) bank rate encourages banks to keep smaller (or greater) proportion of their deposits as reserves, since borrowing from RBI is now less (or more) costly than before. As a result banks use a greater (or smaller) proportion of their resources for giving out loans to borrowers or investors, thereby enhancing (or depressing) the multiplier process via assisting (or resisting) secondary money creation. In short, a low (or high) bank rate reduces (or increases) rdr and hence increases (or decreases) the value of the money multiplier, which is (1 + cdr)/(cdr + rdr). Thus, for any given amount of high powered money, H, total money supply goes up


Varying Reserve Requirements:

Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) also work through the rdr-route. A high (or low) value of CRR or SLR helps increase (or decrease) the value of reserve deposit ratio, thus diminishing (or increasing) the value of the money multiplier and money supply in the economy in a similar fashion.

Sterilisation by RBI:

RBI often uses its instruments of money creation for stabilising the stock of money in the economy from external shocks. Suppose due to future growth prospects in India investors from across the world increase their investments in Indian bonds which under such circumstances, are likely to yield a high rate of return. They will buy these bonds with foreign currency. Since one cannot purchase goods in the domestic market with foreign currency, a person who sells these bonds to foreign investors will exchange her foreign currency holding into rupee at a commercial bank. The bank, in turn, will submit this foreign currency to RBI and its deposits with RBI will be credited with equivalent sum of money. What kind of adjustments take place from this entire transaction? The commercial bank’s total reserves and deposits remain unchanged (it has purchased the foreign currency from the seller using its vault cash, which, therefore, goes down; but the bank’s deposit with RBI goes up by an equivalent amount – leaving its total reserves unchanged). There will, however, be increments in the assets and liabilities on the RBI balance sheet. RBI’s foreign exchange holding goes up. On the other hand, the deposits of commercial banks with RBI also increase by an equal amount. But that means an increase in the stock of high powered money – which, by definition, is equal to the total liability of RBI. With money multiplier in operation, this, in turn, will result in increased money supply in the economy. This increased money supply may not altogether be good for the economy’s health. If the volume of goods and services produced in the economy remains unchanged, the extra money will lead to increase in prices of all commodities. People have more money in their hands with which they compete each other in the commodities market for buying the same old stock of goods. As too much money is now chasing the same old quantities of output, the process ends up in bidding up prices of every commodity – an increase in the general price level,
which is also known as inflation.

RBI often intervenes with its instruments to prevent such an outcome. In the above example, RBI will undertake an open market sale of government securities of an amount equal to the amount of foreign exchange inflow in the economy, thereby keeping the stock of high powered money and total money supply unchanged. Thus it sterilises the economy against adverse external shocks. This operation of RBI is known as sterilisation.
Money supply is, therefore, an important macroeconomic variable. Its overall influence on the values of the equilibrium rate of interest, price level and output of an economy is of great significance. We take up these issues in the next blog.

Exchange of commodities without the mediation of money is called Barter Exchange. It suffers from lack of double coincidence of wants. Money facilitates exchanges by acting as a commonly acceptable medium of exchange. In a modern economy, people hold money broadly from two motives – transaction motive and speculative motive. Supply of money, on the other hand, consists of currency notes and coins, demand and time deposits held by commercial banks, etc. It is classified as narrow and broad money according to the decreasing order of liquidity. In India, the supply of money is regulated by the Reserve Bank of India (RBI) which acts as the monetary authority of the country. Various actions of the public, the commercial banks of the country and RBI are responsible for changes in the supply of money in the economy.
RBI regulates money supply by controlling the stock of high powered money, the bank rate and reserve requirements of the commercial banks. It also sterilises the money supply in the economy against external shocks.

Money Creation by the Banking System


In this section we shall explore the determinants of money supply. Money supply will change if the value of any of its components such as CU, DD or Time Deposits changes. In what follows we shall, for simplicity, use the most liquid definition of money, viz. M1 = CU + DD, as the measure of money supply in the economy. Various actions of the monetary authority, RBI, and commercial banks are responsible for changes in the values of these items. The preference of the public for holding cash balances vis-´a-vis deposits in banks also affect the money supply. These influences on money supply can be summarised by the following key ratios.

The Currency Deposit Ratio:
The currency deposit ratio (cdr) is the ratio of money held by the public in currency to that they hold in bank deposits. cdr = CU/DD. If a person gets Re 1 she will put Rs 1/(1 + cdr) in her bank account and keep Rs cdr/(1 + cdr) in cash. It reflects people’s preference for liquidity. It is a purely behavioural parameter which depends, among other things, on the seasonal pattern of expenditure. For example, cdr increases during the festive season as people convert deposits to cash balance for meeting extra expenditure during such periods.

The Reserve Deposit Ratio:
Banks hold a part of the money people keep in their bank deposits as reserve money and loan out the rest to various investment projects. Reserve money consists of two things – vault cash in banks and deposits of commercial banks with RBI. Banks use this reserve to meet the demand for cash by account holders. Reserve deposit ratio (rdr) is the proportion of the total deposits commercial banks keep as reserves. Keeping reserves is costly for banks, as, otherwise, they could lend this balance to interest earning investment projects. However, RBI requires commercial banks to keep reserves in order to ensure that banks have a safe cushion of assets to draw on when account holders want to be paid. RBI uses various policy instruments to bring forth a healthy rdr in commercial banks. The first instrument is the Cash Reserve Ratio which specifies the fraction of their deposits that banks must keep with RBI. There is another tool called Statutory Liquidity Ratio which requires the banks to maintain a given fraction of their total demand and time deposits in the form of specified liquid assets. Apart from these ratios RBI uses a certain interest rate called the Bank Rate to control the value of rdr. Commercial banks can borrow money from RBI at the bank rate when they run short of reserves. A high bank rate makes such borrowing from RBI costly and, in effect, encourages the commercial banks to maintain a healthy rdr.

Commercial Banks:

Commercial Banks accept deposits from the public and lend out this money to interest earning investment projects. The rate of interest offered by the bank to deposit holders is called the ‘borrowing rate’ and the rate at which banks lend out their reserves to investors is called the ‘lending rate’. The difference between the two rates, called ‘spread’, is the profit that is appropriated by the banks. Deposits are broadly of two types – demand deposits, payable by the banks on demand from the account holder, e.g. current and savings account deposits, and time deposits, which have a fixed period to maturity, e.g. fixed deposits. Lending by commercial banks consists mainly of cash credit, demand and shortterm loans to private investors and banks’ investments in government securities and other approved bonds. The creditworthiness of a person is judged by her current assets or the collateral (a security pledged for the repayment of a loan) she can offer.

High Powered Money:
The total liability of the monetary authority of the country, RBI, is called the monetary base or high powered money. It consists of currency (notes and coins in circulation with the public and vault cash of commercial banks) and deposits held by the Government of India and commercial banks with RBI. If a member of the public produces a currency note to RBI the latter must pay her value equal to the figure printed on the note. Similarly, the deposits are also refundable by RBI on demand from deposit-holders. These items are claims which the general public, government or banks have on RBI and hence are considered to be the liability of RBI. RBI acquires assets against these liabilities. The process can be understood easily if we consider a simple stylised example. Suppose RBI purchases gold or dollars worth Rs 5. It pays for the gold or foreign exchange by issuing currency to the seller. The currency in circulation in the economy thus goes up by Rs 5, an item that shows up on the liability side of the balance sheet. The value of the acquired assets, also equal to Rs 5, is entered under the appropriate head on the Assets side. Similarly, RBI acquires debt bonds or securities issued by the government and pays the government by issuing currency in return. It issues loans to commercial banks in a similar fashion. We are now ready to explain the mechanism of money creation by the monetary authority, RBI. Suppose RBI wishes to increase the money supply. It will then inject additional high powered money into the economy in the following way. Let us assume that RBI purchases some asset, say, government bonds or gold worth Rs H from the market. It will issue a cheque of Rs H on itself to the seller of the bond. Assume also that the values of cdr and rdr for this economy are 1 and 0.2, respectively. The seller encashes the cheque at her account in Bank A, keeping Rs 2 H in her account and taking Rs 2 H away as cash. Currency held by the public thus goes up by 2 H . Bank A’s liability goes up by Rs 2 H because of this increment in deposits. But its assets also go up by the same amount through the possession of this cheque, which is nothing but a claim of the same amount on RBI. The liability of RBI goes up by Rs H, which is the sum total of the claims of Bank A and its client, the seller, worth Rs 2 H and Rs 2 H , respectively. Thus, by definition, high powered money increases by Rs H. The process does not end here. Bank A will keep Rs 0.2 2H of the extra deposit as reserve and loan out the rest, i.e. Rs (1– 0.2) 2H = Rs 0.8 2 H to another borrower3. The borrower will presumably use this loan on some investment project and spend the money as factor payment. Suppose a worker of that project gets the payment. The worker will then keep Rs 0.8 4H as cash and put Rs 0.8 4H in her account in Bank B. Bank B, in turn, will lend Rs 0.64 4H . Someone who receives that money will keep 0.64 8H in cash and put 0.64 8H in some other Bank C. The process continues ad infinitum.

The increment in total money supply exceeds the amount of high powered money initially injected by RBI into the economy. We define money multiplier as the ratio of the stock of money to the stock of high powered money in an economy, viz. M/H. Clearly, its value is greater than 1. We need not always go through the round effects in order to compute the value of the money multiplier. We did it here just to demonstrate the process of money creation in which the commercial banks have an important role to play. However, there exists a simpler way of deriving the multiplier. By definition, money supply is equal to currency plus deposits
M = CU + DD = (1 + cdr )DD
where, cdr = CU/DD.
Assume, for simplicity, that treasury deposit of the Government with RBI is zero. High powered money then consists of currency held by the public and reserves of the commercial banks, which include vault cash and banks’ deposits with RBI. Thus
H = CU + R = cdr.DD + rdr.DD = (cdr + rdr)DD

Narrow and Broad Money

Legal Definitions: Narrow and Broad Money

Money supply, like money demand, is a stock variable. The total stock of money in circulation among the public at a particular point of time is called money supply. RBI publishes figures for four alternative measures of money supply, viz. M1, M2, M3 and M4. They are defined as follows

M1 = CU + DD
M2 = M1 + Savings deposits with Post Office savings banks
M3 = M1 + Net time deposits of commercial banks
M4 = M3 + Total deposits with Post Office savings organisations (excluding National Savings Certificates)

where, CU is currency (notes plus coins) held by the public and DD is net demand deposits held by commercial banks. The word ‘net’ implies that only deposits of the public held by the banks are to be included in money supply. The interbank deposits, which a commercial bank holds in other commercial banks, are not to be regarded as part of money supply.

M1 and M2 are known as narrow money. M3 and M4 are known as broad money. These gradations are in decreasing order of liquidity. M1 is most liquid and easiest for transactions whereas M4 is least liquid of all. M3 is the most commonly used measure of money supply. It is also known as aggregate monetary resources.

THE SUPPLY OF MONEY



In a modern economy money consists mainly of currency notes and coins issued by the monetary authority of the country. In India currency notes are issued by the Reserve Bank of India (RBI), which is the monetary authority in India. However, coins are issued by the Government of India. Apart from currency notes and coins, the balance in savings, or current account deposits, held by the public in commercial banks is also considered money since cheques drawn on these accounts are used to settle transactions. Such deposits are called demand deposits as they are payable by the bank on demand from the accountholder. Other deposits, e.g. fixed deposits, have a fixed period to maturity and are referred to as time deposits. Though a hundred-rupee note can be used to obtain commodities worth Rs 100 from a shop, the value of the paper itself is negligible – certainly less than Rs 100. Similarly, the value of the metal in a five-rupee coin is probably not worth Rs 5. Why then do people accept such notes and coins in exchange of goods which are apparently more valuable than these? The value of the currency notes and coins is derived from the guarantee provided by the issuing authority of these items. Every currency note bears on its face a promise from the Governor of RBI that if someone produces the note to RBI, or any other commercial bank, RBI will be responsible for giving the person purchasing power equal to the value printed on the note. The same is also true of coins. Currency notes and coins are therefore called fiat money. They do not have intrinsic value like a gold or silver coin. They are also called legal tenders as they cannot be refused by any citizen of the country for settlement of any kind of transaction. Cheques drawn on savings or current accounts, however, can be refused by anyone as a mode of payment. Hence, demand deposits are not legal tenders.

DEMAND FOR MONEY


Money is the most liquid of all assets in the sense that it is universally acceptable and hence can be exchanged for other commodities very easily. On the other hand, it has an opportunity cost. If, instead of holding on to a certain cash balance, you put the money in a savings account in some bank you can earn interest on that money. While deciding on how much money to hold at a certain point of time one has to consider the trade off between the advantage of liquidity and the disadvantage of the foregone interest. Demand for money balance is thus often referred to as liquidity preference. People desire to hold money balance broadly from two motives.
The Transaction Motive:

The principal motive for holding money is to carry out transactions. If you receive your income weekly and pay your bills on the first day of every week, you need not hold any cash balance throughout the rest of the week; you may as well ask your employer to deduct your expenses directly from your weekly salary and deposit the balance in your bank account. But our expenditure patterns do not normally match our receipts. People earn incomes at discrete points in time and spend it continuously throughout the interval. Suppose you earn Rs 100 on the first day of every month and run down this balance evenly over the rest of the month. Thus your cash balance at the beginning and end of the month are Rs 100 and 0, respectively. Your average cash holding can then be calculated as (Rs 100 + Rs 0) ÷ 2 = Rs 50, with which you are making transactions worth Rs 100 per month. Hence your average transaction demand for money is equal to half your monthly income, or, in other words, half the value of your monthly transactions.

Consider, next, a two-person economy consisting of two entities – a firm (owned by one person) and a worker. The firm pays the worker a salary of Rs 100 at the beginning of every month. The worker, in turn, spends this income over the month on the output produced by the firm – the only good available in this economy! Thus, at the beginning of each month the worker has a money balance of Rs 100 and the firm a balance of Rs 0. On the last day of the month the picture is reversed – the firm has gathered a balance of Rs 100 through its sales to the worker. The average money holding of the firm as well as the worker is equal to Rs 50 each. Thus the total transaction demand for money in this economy is equal to Rs 100. The total volume of monthly transactions in this economy is Rs 200 – the firm has sold its output worth Rs 100 to the worker and the latter has sold her services worth Rs 100 to the firm. The transaction demand for money of the economy is again a fraction of the total volume of transactions in the economy over the unit period of time.

The two-person economy described above can be looked at from another angle. You may perhaps find it surprising that the economy uses money balance worth only Rs 100 for making transactions worth Rs 200 per month. The answer to this riddle is simple – each rupee is changing hands twice a month. On the first day, it is being transferred from the employer’s pocket to that of the worker and sometime during the month, it is passing from the worker’s hand to the employer’s. The number of times a unit of money changes hands during the unit period is called the velocity of circulation of money. In the above example it is 2, inverse of half – the ratio of money balance and the value of transactions.

We are ultimately interested in learning the relationship between the aggregate transaction demand for money of an economy and the (nominal) GDP in a given year. The total value of annual transactions in an economy includes transactions in all intermediate goods and services and is clearly much greater than the nominal GDP. However, normally, there exists a stable, positive relationship between value of transactions and the nominal GDP. An increase in nominal GDP implies an increase in the total value of transactions and hence a greater transaction demand for money.

The Speculative Motive:

An individual may hold her wealth in the form of landed property, bullion, bonds, money etc. For simplicity, let us club all forms of assets other than money together into a single category called ‘bonds’. Typically, bonds are papers bearing the promise of a future stream of monetary returns over a certain period of time. These papers are issued by governments or firms for borrowing money from the public and they are tradable in the market. Consider the following two-period bond. A firm wishes to raise a loan of Rs 100 from the public. It issues a bond that assures Rs 10 at the end of the first year and Rs 10 plus the principal of Rs 100 at the end of the second year. Such a bond is said to have a face value of Rs 100, a maturity period of two years and a coupon rate of 10 per cent. Assume that the rate of interest prevailing in your savings bank account is equal to 5 per cent. Naturally you would like to compare the earning from this bond with the interest earning of your savings bank account. The exact question that you would ask is as follows: How much money, if kept in my savings bank account, will generate Rs 10 at the end of one year? Let this amount be X. This amount, Rs X, is called the present value of Rs 10 discounted at the market rate of interest. Similarly, let Y be the amount of money which if kept in the savings bank account will generate Rs 110 at the end of two years. Calculation reveals that it is Rs 109.29 (approx.). It means that if you put Rs 109.29 in your savings bank account it will fetch the same return as the bond. But the seller of the bond is offering the same at a face value of only Rs 100. Clearly the bond is more attractive than the savings bank account and people will rush to get hold of the bond. Competitive bidding will raise the price of the bond above its face value, till price of the bond is equal to its PV. If price rises above the PV the bond becomes less attractive compared to the savings bank account and people would like to get rid of it. The bond will be in excess supply and there will be downward pressure on the bond-price which will bring it back to the PV. It is clear that under competitive assets market condition the
price of a bond must always be equal to its present value in equilibrium. Now consider an increase in the market rate of interest from 5 per cent to 6 per cent. The present value, and hence the price of the same bond, will become 107.33 (approx.)

It follows that the price of a bond is inversely related to the market rate of interest. Different people have different expectations regarding the future movements in the market rate of interest based on their private information regarding the economy. If you think that the market rate of interest should eventually settle down to 8 per cent per annum, then you may consider the current rate of 5 per cent too low to be sustainable over time. You expect interest rate to rise and consequently bond prices to fall. If you are a bond holder a decrease in bond price means a loss to you – similar to a loss you would suffer if the value of a property held by you suddenly depreciates in the market. Such a loss occurring from a falling bond price is called a capital loss to the bond holder. Under such circumstances, you will try to sell your bond and hold money instead. Thus speculations regarding future movements in interest rate and bond prices give rise to the speculative demand for money. When the interest rate is very high everyone expects it to fall in future and hence anticipates capital gains from bond-holding. Hence people convert their money into bonds. Thus, speculative demand for money is low. When interest rate comes down, more and more people expect it to rise in the future and anticipate capital loss. Thus they convert their bonds into money giving rise to a high speculative demand for money. Hence speculative demand for money is inversely related to the rate of interest.

As mentioned earlier, interest rate can be thought of as an opportunity cost or ‘price’ of holding money balance. If supply of money in the economy increases and people purchase bonds with this extra money, demand for bonds will go up, bond prices will rise and rate of interest will decline. In other words, with an increased supply of money in the economy the price you have to pay for holding money balance, viz. the rate of interest, should come down. However, if the market rate of interest is already low enough so that everybody expects it to rise in future, causing capital losses, nobody will wish to hold bonds. Everyone in the economy will hold their wealth in money balance and if additional money is injected within the economy it will be used up to satiate people’s craving for money balances without increasing the demand for bonds and without further lowering the rate of interest below the floor rmin. Such a situation is called a liquidity trap. The speculative money demand function is infinitely elastic here.

FUNCTIONS OF MONEY

The first and foremost role of money is that it acts as a medium of exchange. Barter exchanges become extremely difficult in a large economy because of the high costs people would have to incur looking for suitable persons to exchange their surpluses. Money also acts as a convenient unit of account. The value of all goods and services can be expressed in monetary units. When we say that the value of a certain wristwatch is Rs 500 we mean that the wristwatch can be exchanged for 500 units of money, where a unit of money is rupee in this case. If the price of a pencil is Rs 2 and that of a pen is Rs 10 we can calculate the relative price of a pen with respect to a pencil, viz. a pen is worth 10 ÷ 2 = 5 pencils. The same notion can be used to calculate the value of money itself with respect to other commodities. In the above example, a rupee is worth 1 ÷ 2 = 0.5 pencil or 1 ÷ 10 = 0.1 pen. Thus if prices of all commodities increase in terms of money which, in other words, can be regarded as a general increase in the price level, the value of money in terms of any commodity must have decreased – in the sense that a unit of money can now purchase less of any commodity. We call it a deterioration in the purchasing power of money. A barter system has other deficiencies. It is difficult to carry forward one’s wealth under the barter system. Suppose you have an endowment of rice which you do not wish to consume today entirely. You may regard this stock of surplus rice as an asset which you may wish to consume, or even sell off, for acquiring other commodities at some future date. But rice is a perishable item and cannot be stored beyond a certain period. Also, holding the stock of rice requires a lot of space. You may have to spend considerable time and resources looking for people with a demand for rice when you wish to exchange your stock for buying other commodities. This problem can be solved if you sell your rice for money. Money is not perishable and its storage costs are also considerably lower. It is also acceptable to anyone at any point of time. Thus money can act as a store of value for individuals. Wealth can be stored in the form of money for future use. However, to perform this function well, the value of money must be sufficiently stable. A rising price level may erode the purchasing power of money. It may be noted that any asset other than money can also act as a store of value, e.g. gold, landed property, houses or even bonds (to be introduced shortly). However, they may not be easily convertible to other commodities and do not have universal acceptability.

Money and Banking - Introduction

Money is the commonly accepted medium of exchange. In an economy which consists of only one individual there cannot be any exchange of commodities and hence there is no role for money. Even if there are more than one individual but they do not take part in market transactions, such as a family living on an isolated island, money has no function for them. However, as soon as there are more than one economic agent who engage themselves in transactions through the market, money becomes an important instrument for facilitating these exchanges. Economic exchanges without the mediation of money are referred to as barter exchanges. However, they presume the rather improbable double coincidence of wants. Consider, for example, an individual who has a surplus of rice which she wishes to exchange for clothing. If she is not lucky enough she may not be able to find another person who has the diametrically opposite demand for rice with a surplus of clothing to offer in exchange. The search costs may become prohibitive as the number of individuals increases. Thus, to smoothen the transaction, an intermediate good is necessary which is acceptable to both parties. Such a good is called money. The individuals can then sell their produces for money and use this money to purchase the commodities they need. Though facilitation of exchanges is considered to be the principal role of money, it serves other purposes as well. Following are the main functions of money in a modern economy.

GDP AND WELFARE

Can the GDP of a country be taken as an index of the welfare of the people of that country? If a person has more income he or she can buy more goods and services and his or her material well-being improves. So it may seem reasonable to treat his or her income level as his or her level of well-being. GDP is the sum total of value of goods and services created within the geographical boundary of a country in a particular year. It gets distributed among the people as incomes (except for retained earnings). So we may be tempted to treat higher level of GDP of a country as an index of greater well-being of the people of that country (to account for price changes, we may take the value of real GDP instead of nominal GDP). But there are at least three reasons why this may not be correct

1. Distribution of GDP – how uniform is it:
If the GDP of the country is rising, the welfare may not rise as a consequence. This is because the rise in GDP may be concentrated in the hands of very few individuals or firms. For the rest, the income may in fact have fallen. In such a case the welfare of the entire country cannot be said to have increased. For example, suppose in year 2000, an imaginary country had 100 individuals each earning Rs 10. Therefore the GDP of the country was Rs 1,000 (by income method). In 2001, let us suppose the same country had 90 individuals earning Rs 9 each, and the rest 10 individual earning Rs 20 each. Suppose there had been no change in the prices of goods and services between these two periods. The GDP of the country in the year 2001 was 90 × (Rs 9) + 10 × (Rs 20) = Rs 810 + Rs 200 = Rs 1,010. Observe that compared to 2000, the GDP of the country in 2001 was higher by Rs10. But this has happened when 90 per cent of people of the country have seen a drop in their real income by 10 per cent (from Rs 10 to Rs 9), whereas only 10 per cent have benefited by a rise in their income by 100 per cent (from Rs 10 to Rs 20). 90 per cent of the people are worse off though the GDP of the country has gone up. If we relate welfare improvement in the country to the percentage of people who are better off, then surely GDP is not a good index.

2. Non-monetary exchanges:
Many activities in an economy are not evaluated in monetary terms. For example, the domestic services women perform at home are not paid for. The exchanges which take place in the informal sector without the help of money are called barter exchanges. In barter exchanges goods (or services) are directly exchanged against each other. But since money is not being used here, these exchanges are not registered as part of economic activity. In developing countries, where many remote regions are underdeveloped, these kinds of exchanges do take place, but they are generally not counted in the GDPs of these countries. This is a case of underestimation of GDP. Hence GDP calculated in the standard manner may not give us a clear indication of the productive activity and well-being of a country.


3. Externalities:
Externalities refer to the benefits (or harms) a firm or an individual causes to another for which they are not paid (or penalised). Externalities do not have any market in which they can be bought and sold. For example, let us suppose there is an oil refinery which refines crude petroleum and sells it in the market. The output of the refinery is the amount of oil it refines. We can estimate the value added of the refinery by deducting the value of intermediate goods used by the refinery (crude oil in this case) from the value of its output. The value added of the refinery will be counted as part of the GDP of the economy. But in carrying out the production the refinery may also be polluting the nearby river. This may cause harm to the people who use the water of the river. Hence their utility will fall. Pollution may also kill fish or other organisms of the river on which fish survive. As a result the fishermen of the river may be losing their income and utility. Such harmful effects that the refinery is inflicting on others, for which it does not have to bear any cost, are called externalities. In this case, the GDP is not taking into account such negative externalities. Therefore, if we take GDP as a measure of welfare of the economy we shall be overestimating the actual welfare. This was an example of negative externality. There can be cases of positive externalities as well. In such cases GDP will underestimate the actual welfare of the economy.

GOODS AND PRICES


One implicit assumption in all this discussion is that the prices of goods and services do not change during the period of our study. If prices change, then there may be difficulties in comparing GDPs. If we measure the GDP of a country in two consecutive years and see that the figure for GDP of the latter year is twice that of the previous year, we may conclude that the volume of production of the country has doubled. But it is possible that only prices of all goods and services have doubled between the two years whereas the production has remained constant. Therefore, in order to compare the GDP figures (and other macroeconomic variables) of different countries or to compare the GDP figures of the same country at different points of time, we cannot rely on GDPs evaluated at current market prices.
For comparison we take the help of real GDP. Real GDP is calculated in a way such that the goods and services are evaluated at some constant set of prices (or constant prices). Since these prices remain fixed, if the Real GDP changes we can be sure that it is the volume of production which is undergoing changes. Nominal GDP, on the other hand, is simply the value of GDP at the current prevailing prices. For example, suppose a country only produces bread. In the year 2000 it had produced 100 units of bread, price was Rs 10 per bread. GDP at current price was Rs 1,000. In 2001 the same country produced 110 units of bread at price Rs 15 per bread. Therefore nominal GDP in 2001 was Rs 1,650 (=110 × Rs 15). Real GDP in 2001 calculated at the price of the year 2000 (2000 will be called the base year) will be 110 × Rs 10 = Rs 1,100. Notice that the ratio of nominal GDP to real GDP gives us an idea of how the prices have moved from the base year (the year whose prices are being used to calculate the real GDP) to the current year. In the calculation of real and nominal GDP of the current year, the volume of production is fixed. Therefore, if these measures differ it is only due to change in the price level between the base year and the current year. The ratio of nominal to real GDP is a well known index of prices. This is called GDP Deflator. Thus if GDP stands for nominal GDP and gdp stands for real GDP then, GDP deflator = GDP gdp . Sometimes the deflator is also denoted in percentage terms. In such a case deflator = GDP gdp × 100 per cent. In the previous example, the GDP deflator is 1,650 1,100 = 1.50 (in percentage terms this is 150 per cent). This implies that the price of bread produced in 2001 was 1.5 times the price in 2000. Which is true because price of bread has indeed gone up from Rs 10 to Rs 15. Like GDP deflator, we can have GNP deflator as well. There is another way to measure change of prices in an economy which is known as the Consumer Price Index (CPI). This is the index of prices of a given basket of commodities which are bought by the representative consumer. CPI is generally expressed in percentage terms. We have two years under consideration – one is the base year, the other is the current year. We calculate the cost of purchase of a given basket of commodities in the base year. We also calculate the cost of purchase of the same basket in the current year. Then we express the latter as a percentage of the former. This gives us the Consumer Price Index of the current year vis-´a-vis the base year. For example let us take an economy which produces two goods, rice and cloth. A representative consumer buys 90 kg of rice and 5 pieces of cloth in a year. Suppose in the year 2000 the price of a kg of rice was Rs 10 and a piece of cloth was Rs 100. So the consumer had to spend a total sum of Rs 10 × 90 = Rs 900 on rice in 2000. Similarly, she spent Rs 100 × 5 = Rs 500 per year on cloth. Summation of the two items is, Rs 900 + Rs 500 = Rs 1,400.


Now suppose the prices of a kg of rice and a piece of cloth has gone up to Rs 15 and Rs 120 in the year 2005. To buy the same quantity of rice and clothes the representative will have to spend Rs 1,350 and Rs 600 respectively (calculated in a similar way as before). Their sum will be, Rs 1,350 + Rs 600 = Rs 1,950. The CPI therefore will be 1,950 1,400 × 100 = 139.29 (approximately).

It is worth noting that many commodities have two sets of prices. One is the retail price which the consumer actually pays. The other is the wholesale price, the price at which goods are traded in bulk. These two may differ in value because of the margin kept by traders. Goods which are traded in bulk (such as raw materials or semi-finished goods) are not purchased by ordinary consumers. Like CPI, the index for wholesale prices is called Wholesale Price Index (WPI). In countries like USA it is referred to as Producer Price Index (PPI). Notice CPI (and analogously WPI) may differ from GDP deflator because
  1. The goods purchased by consumers do not represent all the goods which are produced in a country. GDP deflator takes into account all such goods and services.
  2. CPI includes prices of goods consumed by the representative consumer, hence it includes prices of imported goods. GDP deflator does not include prices of imported goods.
  3. The weights are constant in CPI – but they differ according to production level of each good in GDP deflator.

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