MONEY FUNCTION AND CLASSIFICATION
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Medium of Exchange: Money acts as an intermediary in trade. Instead of engaging in direct barter, where goods and services are exchanged for other goods and services, individuals and businesses use money to facilitate transactions. Money makes trade more efficient by providing a widely accepted and easily transferable medium of exchange.
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Unit of Account: Money provides a common unit of measurement for the value of goods and services. It allows for easy comparison of prices and simplifies financial calculations. Without a unit of account, it would be challenging to determine the relative value of different items and make informed economic decisions.
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Store of Value: Money serves as a store of value, meaning it can be saved and used for future transactions. Unlike perishable or highly volatile commodities, money retains its value over time. People can save money in various forms, such as bank deposits or cash, and expect it to maintain its purchasing power.
In India, like in many other countries, the money supply is classified into several categories, often referred to as "Monetary Aggregates" or "Measures of Money Supply." These measures vary in terms of liquidity and how closely they represent different forms of money in the economy. The Reserve Bank of India (RBI), India's central bank, uses these classifications to monitor and control the money supply in the economy. As of my knowledge cutoff date in September 2021, the primary measures of money supply in India include:
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M0 (Reserve Money): M0 is the most liquid form of money and represents the total currency in circulation (coins and paper currency) held by the public and the cash reserves of commercial banks with the central bank (RBI). It is also known as "Reserve Money" and serves as the monetary base upon which the money supply expands.
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M1 (Narrow Money): M1 is a broader measure of money supply and includes M0 along with demand deposits (current account and savings account) with commercial banks. M1 represents money that can be quickly accessed and used for transactions.
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M2 (Broad Money): M2 is an even broader measure of money supply and includes M1 along with time deposits (fixed deposits) held with commercial banks. M2 represents a more comprehensive view of money in circulation and savings.
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M3: M3 includes M2 along with certain quasi-money assets, such as certificate of deposits issued by banks and non-banking financial companies (NBFCs). M3 provides a more extensive measure of money supply, including near-money assets.
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M4 (Broad Money): M4 is the broadest measure of money supply in India. It includes M3 along with all post office savings deposits. M4 is the most comprehensive representation of money in circulation, including savings in both banks and post office accounts.
Broad money and narrow money are terms used to describe different categories of money supply within an economy. These classifications help economists and policymakers understand the liquidity and depth of money in circulation. Here's an explanation of broad money (M2) and narrow money (M1):
1. Narrow Money (M1):
Narrow money, often referred to as M1, represents the most liquid forms of money in an economy. It includes the following components:
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Currency in Circulation (CIC): This refers to the physical currency (coins and banknotes) held by the public and not deposited in banks. CIC is the money that people carry in their wallets and use for daily transactions.
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Demand Deposits (DD): Demand deposits are also known as checking or current accounts. These are bank accounts that allow account holders to make withdrawals on demand without prior notice. Money in demand deposits is highly liquid and can be used for everyday transactions through checks, debit cards, or online transfers.
M1 represents the narrowest definition of money supply because it includes only the most liquid assets that can be used for immediate transactions. It serves as a critical indicator of an economy's liquidity and is often used for measuring the money supply's immediate impact on inflation and economic activity.
2. Broad Money (M2):
Broad money, often referred to as M2, represents a broader definition of money supply. It includes all the components of M1 and adds other, less liquid assets. In addition to currency in circulation and demand deposits, M2 typically includes the following components:
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Savings Deposits (including recurring deposits): Savings deposits are bank accounts where individuals and businesses can save money and earn interest. These funds are less liquid than demand deposits but are still accessible without significant restrictions.
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Time Deposits (Fixed Deposits or Certificates of Deposit): Time deposits are accounts where individuals deposit money for a specific term, often with higher interest rates than savings accounts. However, they are less liquid because withdrawing money before the term's end may result in penalties.
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Money Market Funds (MMFs): Money market funds are mutual funds that invest in short-term, highly liquid securities. While not technically part of the traditional money supply, they are considered near-money assets because they can be quickly converted into cash.
Broad money, represented by M2, provides a more comprehensive view of an economy's money supply. It includes assets that are not as immediately accessible as those in M1 but are still part of the overall monetary system. M2 is useful for assessing the overall health and stability of an economy, as it reflects the availability of funds for investment and consumption beyond immediate transactions.
Both M1 and M2 are important indicators for central banks and policymakers to monitor and manage, as they play a crucial role in influencing economic growth, inflation, and monetary policy decisions
Money Multiplier
The money multiplier is an important concept in monetary economics that explains how a change in the monetary base (e.g., currency in circulation and bank reserves) can result in a larger change in the money supply through the fractional reserve banking system. It represents the relationship between the monetary base and the money supply in an economy. The formula for the money multiplier is:
Money Multiplier = 1 / Reserve Ratio
Here's a breakdown of the components and how the money multiplier works:
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Reserve Ratio (RR): The reserve ratio is the percentage of deposits that banks are required to hold in reserve as cash or as deposits with the central bank. It's set by the central bank as part of its monetary policy. The reserve ratio is expressed as a fraction or percentage. For example, if the reserve ratio is 10%, it means banks are required to hold 10% of their deposits in reserve.
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Money Multiplier (MM): The money multiplier represents the factor by which the money supply can be expanded through the banking system. It is calculated by taking the reciprocal of the reserve ratio.
- If the reserve ratio is 10% (0.10 as a decimal), the money multiplier is 1 / 0.10 = 10.
- If the reserve ratio is 20% (0.20 as a decimal), the money multiplier is 1 / 0.20 = 5.
- And so on.
How the Money Multiplier Works:
The money multiplier concept illustrates how banks create money in a fractional reserve banking system. When individuals or businesses deposit money in a bank, the bank is required to hold only a portion of those deposits as reserves, based on the reserve ratio. The remaining portion of the deposits can be lent out to borrowers.
When banks make loans, the money supply increases because borrowers receive the loan amount in their bank accounts. These borrowers can then use the borrowed funds for various purposes, including making purchases or paying off debts. The recipients of these funds may also deposit the money in their own bank accounts, leading to a new round of lending and deposit creation.
The process continues, with each round of lending and deposit creation, until the total increase in money supply equals the initial deposit amount divided by the reserve ratio. This process is based on the assumption that banks fully utilize their lending capacity and that the newly created money remains within the banking system
Digital Money
Digital money, also known as electronic money (e-money) or digital currency, refers to a form of currency that exists only in electronic form, without a physical counterpart like coins or banknotes. Digital money can be used for various financial transactions and is becoming increasingly prevalent in today's modern economy. Here are some key aspects of digital money:
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Electronic Transactions: Digital money facilitates electronic transactions through digital platforms and devices. It allows individuals and businesses to transfer funds, make payments, and conduct financial activities electronically, often using the internet or mobile applications.
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Types of Digital Money:
- Digital Representations of Fiat Currency: This includes digital versions of traditional currencies issued by central banks and government authorities. For example, many countries have digital versions of their national currencies available for use in online banking and digital payment systems.
- Cryptocurrencies: Cryptocurrencies are decentralized digital currencies that use cryptographic techniques to secure transactions and control the creation of new units. Bitcoin, Ethereum, and Litecoin are examples of cryptocurrencies that operate on blockchain technology.
- Central Bank Digital Currencies (CBDCs): Some central banks are exploring or developing their own digital currencies. CBDCs are digital versions of a country's official currency issued and regulated by the central bank.
- Electronic Money Issuers: Various financial institutions and technology companies issue digital money in the form of prepaid cards, mobile wallets, or digital payment apps. These funds are often held electronically and can be used for online and in-person transactions.
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Advantages of Digital Money:
- Convenience: Digital money allows for quick and easy transactions, reducing the need for physical cash and checks.
- Security: Digital transactions can be more secure through encryption and authentication methods.
- Accessibility: Digital money is accessible 24/7 through online banking and mobile apps.
- Global Transactions: Digital currencies like cryptocurrencies enable international transactions without the need for currency conversion.
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Challenges and Considerations:
- Security Concerns: While digital money offers security advantages, it can also be vulnerable to cyberattacks and fraud.
- Regulation: Regulatory frameworks for digital money vary by country and can impact its use and adoption.
- Privacy: Some forms of digital money may raise concerns about privacy and the tracking of financial transactions.
Monetary policy is a crucial tool used by central banks to manage and control a country's money supply, interest rates, and overall economic stability. Its primary objective is to achieve specific economic goals, typically centered around price stability, full employment, and sustainable economic growth. Here's an overview of monetary policy, its tools, objectives, and how it works:
Objectives of Monetary Policy:
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Price Stability: Maintaining stable prices and controlling inflation is one of the primary goals of monetary policy. Central banks aim to keep inflation within a target range to preserve the purchasing power of a country's currency.
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Full Employment: Monetary policy can also be used to influence employment levels. By managing interest rates and money supply, central banks seek to create conditions conducive to maximum sustainable employment.
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Economic Growth: Encouraging economic growth is another objective. Central banks may use monetary policy to stimulate or moderate economic activity, depending on the economic conditions and goals.
Tools of Monetary Policy:
Central banks use various tools to implement monetary policy. The effectiveness of these tools depends on the specific goals and economic circumstances. Common monetary policy tools include:
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Interest Rates: Adjusting short-term interest rates is a primary tool. Lowering interest rates encourages borrowing and spending, stimulating economic activity. Conversely, raising interest rates can cool an overheating economy and control inflation.
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Open Market Operations: Central banks buy or sell government securities in the open market to control the money supply. Buying securities injects money into the economy, while selling them withdraws money.
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Reserve Requirements: Central banks can change the amount of reserves that banks are required to hold. Lowering reserve requirements can encourage banks to lend more, thereby increasing the money supply.
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Discount Rate: The discount rate is the interest rate at which banks can borrow money from the central bank. A change in the discount rate can influence banks' lending and borrowing behavior.
A Monetary Policy Committee (MPC) is a committee or group of policymakers within a central bank responsible for making decisions regarding the monetary policy of a country or economic region. The primary function of an MPC is to set and adjust key monetary policy parameters, such as interest rates, in order to achieve specific economic goals, typically centered around price stability and sometimes including employment and economic growth targets. MPCs are a common feature of many central banks around the world. Here are the key aspects of an MPC:
Composition:
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Members: An MPC typically consists of a group of members, including both central bank officials and external, independent experts. The exact composition can vary from one country to another.
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Independence: Many central banks strive for independence in their monetary policy decisions to insulate them from political pressures that could compromise their ability to make objective and effective policy choices. Having external, independent experts on the MPC can help enhance this independence.
Functions and Responsibilities:
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Setting Interest Rates: One of the primary functions of an MPC is to set the benchmark interest rate (e.g., the policy rate or the repo rate) for the country's monetary system. This interest rate directly influences borrowing costs, spending, and overall economic activity.
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Economic Analysis: The MPC conducts an in-depth analysis of various economic indicators, including inflation, employment, GDP growth, and financial market conditions. This analysis informs the committee's decisions regarding interest rate adjustments.
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Policy Implementation: The MPC decides whether to raise, lower, or maintain interest rates based on its assessment of the economic environment. Interest rate changes are used to achieve the central bank's monetary policy objectives, such as controlling inflation within a target range.
Decision-Making Process:
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Regular Meetings: MPCs typically meet at regular intervals (e.g., monthly or quarterly) to review economic conditions and consider potential changes to monetary policy.
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Consensus Decision: Decisions are often reached through a consensus among MPC members. The committee discusses various options and considerations before arriving at a decision.
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Transparent and Accountable: Many central banks emphasize transparency and accountability in their decision-making processes. They release meeting minutes, policy statements, and sometimes even publish forecasts to provide insights into their thinking and reasoning.
Examples of MPCs:
- The United Kingdom has a Monetary Policy Committee (MPC) within the Bank of England responsible for setting interest rates and achieving the government's inflation target.
- The European Central Bank (ECB) has its own version of an MPC known as the Governing Council, responsible for making monetary policy decisions for the eurozone.
- The Federal Open Market Committee (FOMC) is the MPC equivalent in the United States, responsible for setting the federal funds rate, which influences monetary policy in the U.S.
