Very Short Question Answer
1. Define money supply.
Money supply is defined as the total stock of money held by people and financial institutions including the central bank at a particular point of time. In other words, money supply is the total quantity of money circulation in an economy.
2. What do you mean by narrow money?
Narrow money is the money supply which includes currency held by public, demand deposits with commercial banks including other deposits held at central bank. It is also known as the ordinary money. It is denoted by M₁.
M₁ = C + DD Where,
C = Currency held by public
DD = Demand deposits held at commercial bank including other deposits of central bank.
3. Define the broad money.
Broad money is defined as the sum of narrow money and time deposits consisting of saving deposits, fixed deposits, call deposits and margin deposits. It is denoted by M₂.
M₂ = M₁ + TD
M₁ = Narrow money
TD= Time deposits with banks
4. Define the meaning of high power money.
High power money is the total sum of currency held by public, cash held by commercial banks in their vault, commercial banks’ balances with central bank and other deposits held at central bank. It is also known as the reserve money or monetary base. It is denoted by H.
C = Currency held by public
5. What is meant by the transaction motive of demand for money?
The transaction motive of demand for money means demand for money or need of cash for daily expenditure. It is interest inelastic but income elastic.
6. Define the meaning of precautionary demand for money.
The precautionary demand for money is defined as the demand for money in order to meet emergencies and unforeseen crises such as sickness, unemployment, accidents, etc. This is income elastic but interest inelastic.
7. Define money market.
Money market is defined as the market for short-term financial assets which have maturity period less than one year. The credit instruments of money market are bills of exchange, treasury bills, certificates of deposits, commercial papers, etc.
8. Define capital market.
Capital market is defined as the market for long-term financial assets which have maturity period more than one year. The capital market uses credit instruments like shares, debentures, bonds, etc.
Short Question Answer
1. Explain the concepts of money supply.
Money supply is defined as the total stock of money held by people and financial institutions including the central bank at a particular point of time. In other words, it is the total stock of monetary media of exchange available to a society for use in connection with economic activity of the country. According to standard concept, it is composed of two elements: currency with the public and demand deposits with the public. Generally, money supply is exogenously determined by central bank of the country. It is both stock and flow concept. When money supply is viewed at a particular point of time, it is stock concept and when money supply in viewed as over a period of time, it is flow concept.
There are several definitions of money supply. Therefore, there are various measures of money supply. Among them, important measures of money supply are important, which are as follows:
i. Money supply M₁ (Narrow money): Narrow money or M₁ is the narrow measure of money supply. It includes currency with public and demand deposit with commercial banks including other deposits of public with central bank t the country.
M1 =C + DD
M1= Narrow money
C – Currency held by public
DD Demand deposits with the public in commercial bank and other deposits of public with central bank
ii. Money supply M₂ (Board money): M₂ is a broad concept of money supply. In addition to narrow money or money supply M₁, money supply M₂ consists of saving deposits, fixed deposits, call deposits and margin deposits.
M₂ = M₁ + TD
TD=Time deposits including saving, fixed, cal’ and margin deposits.
2. Define money supply. Explain the determinants of money supply.
Money supply is defined as the total stock of money held by people and financial institutions including the central bank at a particular point of time. It is, in fact, total circulation of money in the country. It is exogenously determined by central bank of the country. It is both flow and stock concept. It is measured at a point of time, then, it is stock concept and if it is measured over a period of time, then, it is flow concept.
The important determinants of money supply are as follows:
i. High power money (H): High power money consists of currency issued by central bank of the country. A part of currency issued is held by public and a part is held by the banks as reserves. Hence, high power money is the sum of currency held by public, cash held by commercial banks in their vault, commercial banks’ balances with the central bank and other deposits at the central bank. High power money is also known as the reserve money or monetary base. Thus,
H = C + CV + CBB + OD
H = High power money
C = Currency held by public
CV =Cash vault of commercial banks
CBB =Commercial banks’ balance with the central bank
OD =Other deposits with the central bank
High power money is the base of expansion of bank credit and creation of money supply. The money supply varies directly with changes in monetary base high power money and inversely with the currency and reserve ratio. ii. Money multiplier (m): The relation between money supply and the high power money is determined by the money multiplier. The money multiplier is denoted by ‘m’, which is the ratio of total money supply (M) and high power money (H).
m= M /H
or, M = m.H
Thus, money supply is determined by the size of money multiplier (m) and the amount of high power money (H). If we know the value of money multiplier, we can predict money supply at the given high power money. High power money is decided and controlled by central bank. The size of money multiplier is determined by the cash reserve ratio of banks and currency deposit ratio of the public.
ii. Cash reserve ratio (CRR): Cash reserve ratio is an important determinant of money supply. It is also known as the minimum cash reserve ratio or reserve deposits ratio. It refers to the part of bank deposit that banks hold but not loan out. If cash reserve ratio is increased, money supply decreases and vice-versa. The cash reserve ratio is determined by the law. Every commercial bank is required to keep a certain percentage of their deposits in the form of reserve with the central bank or cash in their vault.
iii. Open market operation: Open market operation refers to the purchase and sale of government securities and other types of assets like bills, securities, bonds, etc. by the central bank. By using this instrument, central bank expands and contracts bank reserve. When central bank purchases securities in the open market, the level of bank reserve and money market increases. On the other hand, when central bank sells securities to the public and banks, the level of bank reserve and money supply decrease.
iv. Other factors: Money supply is also determined by other factors like rate of interest, income, public desire to hold currency and deposits etc. It is also influenced by business activities, behaviour of public and banks etc.
3. Define money market. Explain its functions.
Money market is defined as the market which deals with short-term borrowing and lending of funds. In other words, money market is the institutional arrangement which deals with short-term funds. It deals with short-term credits which are quickly marketable assets, such as, short-term government securities, treasury bills, bills of exchange, etc. The maturity period of credit instruments in the money market less then one year.
The major functions of money market are as follows:
i. To promote economic growth: Money market can promote economic growth making funds available to various sectors of the economy such as agriculture sector, business sector, industrial sector, etc. It leads to increase in the level of income, employment and output and accelerates the economic growth.
ii. To help in capital formation: Money market plays very important role in the capital formation. A developed and competitive money market tends to establish equilibrium between saving and investment, i.e. supply and demand for loanable funds. It, thus, encourages not only saving and investment but also helps to transferring funds from one sector to another sector. In this way, money market plays very important role in accelerating the process of capital formation.
iii. To maintain monetary equilibrium: Money market keeps balance between the demand for money and supply of money for short-term monetary transaction in the economy. Hence, money market maintains the equality between demand for money and supply of money.
iv. Development of trade and industry: The development of trade and industry needs adequate finance. Money market provides adequate finance to the trade and industrial sector. Money market also plays very important role in financing external trade. It provides short-term loans to the industrial sector to meet their working capital requirements though the system of finance bills, commerical papers, etc.
v. Help to the government: Well developed money market also helps the government. It helps government in two ways: (a) it enables the government to borrow short-term funds through treasury bills at a very low rate of interest (b) It helps government in floating long terms loans because of the fact that the change in the short-term interest rates of the money market influence the rates of interest on the long-term capital.
vi. Profitable investment: Money market helps commercial banks to use their excess reserves in the profitable investments. The main objective of commercial banks is to earn profit. Therefore, they use their reserve as well as maintain liquidity to meet the uncertain cash demand of the depositors. In the money market, excess reserves of commercial banks is invested in the highly liquid assets like short-term bill of exchange.
4. Define capital market. Explain its functions.
Capital market is defined as the market which deals with the medium and long term borrowing and lending of funds. In other words, it is the market which deals with medium and long-term financial assets. Here, medium-term refers to the one year to five years and long-term refers to the more than five years. The financial assets or instruments of capital market are bonds, debentures, equities, shares, stocks, etc. It fulfils long-term financial requirement of industrial sectors.
The important functions of capital market are as follows:
i. Mobilization of saving: Capital market is an important source for mobilization of savings. It mobilizes savings from people for further investments in the productive channels of an economy. In other words, it serves as the catalyst helping to convert savings into physical assets in both private and public sector.
ii. Capital formation: Capital market helps in capital formation. Capital formation is the net addition to existing stock of capital in the economy. Through mobilization of idle resources, it generates saving. The mobilized savings are made available in various sectors of the economy such as agriculture, industry, etc. Thus, this helps in capital formation.
iii. Economic growth and development: Capital market leads to increase in production and productivity in the economy. As it makes funds available for the long period of time, the financial requirements of the business and industrial sector are met by the capital market. It also helps in research and development. This help in increasing production and productivity by generation of employment and development of infrastructure. This leads to rapids economic growth and development.
iv. Services Provision: As an important financial set up, capital market provides various types of services. It includes long-term and medium-term loans to industry, business and trade sector, etc. of the economy. This service is very helpful in manufacturing sector of the economy.
v. Continuous availability of funds: Capital market is the market for long-term investment. This can also be regarded as the liquid market because it makes funds available on continuous basis. Both buyers and sellers can easily buy and sell securities as they are continuously available. Basically, capital market transactions are related to the stock exchanges. Thus, marketability capital market becomes easy. The
vi. Proper allocation of funds: A capital market not only helps in funds mobilization, but also proper allocation of these resources. The various institutions of capital market allocate the resources rationally in accordance with the development need of the country. The proper allocation and regulation of funds or resources results expansion of trade and industrial sector in the economy.
5. Define monetary policy. Explain its objectives.
Monetary policy is defined as the macroeconomic policy which is concerned with the management of the money supply in the economy. In other words, monetary policy is the exercise of the central bank’s control over the money supply as an instrument for achieving the objectives or goals of monetary policy are: economic growth, employment, price stability, foreign exchange rate stability, etc.
The objectives or goals of monetary policy depend upon the macroeconomic conditions of an economy. The common objectives of monetary policy are as follows:
i. Full employment: The most important objective of the monetary policy is to achieve full employment of the all resources in the economy. Keynes has also emphasized the role of monetary policy in promoting full employment in the economy. According to him, unemployment is caused due to deficiency of investment and the level of employment can be increased by increasing investment to the level that exceeds saving. Thus, to achieve full employment, monetary policy has to expand the money supply and reduce the rate of interest. Such a type of monetary policy which helps to increase investment to achieve full employment is called is commonly called cheap monetary policy or expansionary monetary policy.
ii. Economic growth and stability: High economic growth can be achieved through expansionary monetary policy. For this, the central bank increases the money supply which reduces the rate of interest. The reduction in the rate of interest encourages investment which results in increase in production and level of income and there by economic growth. With higher economic growth, economic stability is also desirable. During economic depression, expansionary monetary policy should be adopted to achieve economic stability.
iii. Price stability: Price stability refers to the policy of keeping price level stable. It does not mean fixed price level. It simply means that average or general price level should not fluctuate beyond a certain limit. Generally, 2 to 4 percentage rise in price level is considered stable price level. The fluctuation in price level creates inflation and deflation. Both are harmful. Therefore, central bank establishes price stability adopting expansionary and contrationary monetary policy. Expansionary monetary policy is adopted during deflationary period and contractionary monetary policy is adopted during inflationary period.
iv. Exchange rate stability: Exchange rate is defined as the rate at which one currency is exchanged with the currency of another country. Exchange rate stability is an important objective of monetary policy. The stable exchange rate creates confidence and promotes international trade smoothly on a large scale. So, the countries involved in international trade maintain stable exchange rate. Monetary policy plays an important role in maintaining stable exchange rate.
v. Favourable balance of payments: Balance of payment is the systematic record of receipt and payment of a country with rest of the world. When receipt and payment are equal, it is called condition of external sector equilibrium. Generally, developing countries import finished goods like machineries, equipment, etc. of high price and export primary products of low price. Hence, they are facing deficit balance of payment. The monetary policy can correct such kind of deficit balance of payment by the devaluation of domestic currency. The devaluation of domestic currency decreases the volume of import and increases of volume of export and corrects deficit balance of payment.
6. Define monetary policy. Explain its types.
DEFINITION OF MONETARY POLICY
Please refer to Q.No. 5.
There are two types of monetary policy, which are as follows:
i. Expansionary monetary policy: Expansionary monetary policy is defined as the monetary policy in which central bank increases money supply. In other words, it is the action taken by central bank to increase money supply. Central bank increases money supply by purchasing treasury bill and bonds in the open market, decreasing bank rate and reducing cash reserve ratio. Such kind of monetary policy is designed to increase aggregate demand. It is used to overcome a recession or a depression. When there is a fall in consumer demand for goods and services as well as business demand for investment goods, the central bank adopts expansionary monetary policy. Expansionary monetary policy is also called ease or cheap monetary policy: It is because it eases the credit market and decreases cost and availability of credit in the money market.
ii. Contractionary monetary policy: Contractionary monetary policy is defined as the monetary policy in which central bank decrease money supply. In other words, it is the action taken by the central bank to reduce money supply. Central bank reduces money supply by selling treasury bills and bonds in open market, increasing bank rate and cash reserve ratio. Such kind of monetary policy is designed to decrease aggregate demand in the economy. It is used to overcome inflationary gap. When economy experiences inflationary pressure, due to rising consumer’s demand for goods and services and boom in business investment, the central bank starts contractionary monetary policy. Contractionary monetary policy is also known as the restrictive or tight or dearer monetary policy. It is because it tights the credit market and increases the cost and availability of credit in the money market.