Macro Economics CBMBE4T03

Syllabus topics (RTMNU)

• Evolution of Money – Barter system, Metal Money, Paper Currency
• Nature, function and Feature of Money
• Paper Currency - Role of Paper Currency
• Importance
• Issuing authority
• Methods of Note Issue: Fixed Fiduciary Method, Proportional Reserve Method, Minimum Reserve Method

Evolution of Money: Barter System, Metal Money and Paper Currency

Money did not come at once; it developed step by step as trade grew.

1. Barter system: direct exchange of goods for goods (wheat for cloth). It was used in early villages; in India the old baluta system of payment in grain is an example.

Difficulties of barter:

1. Lack of double coincidence of wants: a farmer with wheat who wants shoes must find a cobbler who wants wheat.
2. No common measure of value: how many kg of rice equal one goat?
3. Indivisibility of goods: a cow cannot be cut to buy a small item.
4. Difficulty of storing value: grain and vegetables perish.
5. No standard for deferred payments: loans in goods create disputes.

2. Commodity money: commonly accepted goods such as cattle, grain, shells and salt were used as money.

3. Metal money: metals like gold, silver and copper were used because they are durable, divisible and valuable. Later, coins of fixed weight and stamp were minted by rulers (e.g. the punch-marked coins of ancient India and Sher Shah Suri's silver rupiya).

4. Paper money: goldsmiths gave receipts for gold kept with them; these receipts began to circulate. Today paper notes are issued by the central bank.

5. Credit / bank money and digital money: cheques, drafts, debit and credit cards, and now UPI and the RBI's digital rupee (e-₹).

Nature, Functions and Features of Money

Definition: Crowther — "Money can be defined as anything that is generally acceptable as a means of exchange and at the same time acts as a measure and a store of value." Walker — "Money is what money does."

Nature / features: general acceptability; legal backing (legal tender); medium of exchange; easily portable; divisible; durable; uniform; stable in value (ideally); and it is a means, not an end in itself.

Functions of money (Kinley's classification):

Paper Currency: Role, Importance and Issuing Authority

Meaning: Paper currency means notes printed on paper and accepted as legal tender. Its value does not come from the paper but from the law and public trust.

Role and importance (merits):

1. Economical: printing notes is cheaper than minting gold coins; precious metal is saved.
2. Convenient and portable: large sums can be carried easily.
3. Elastic supply: the central bank can increase or reduce notes as per the needs of trade.
4. Easy counting and transfer.
5. Helps economic development by supporting trade and banking.
6. Useful in emergencies like war, when government needs funds.

Demerits: danger of over-issue and inflation; no intrinsic value; not acceptable abroad; can be damaged or counterfeited.

Issuing authority in India: Under Section 22 of the RBI Act, 1934, the Reserve Bank of India has the sole right to issue bank notes. The ₹1 note and all coins are issued by the Government of India (Ministry of Finance) and put into circulation through the RBI. Every RBI note carries the Governor's signature and the promise "I promise to pay the bearer…"; the ₹1 note carries the Finance Secretary's signature.

Methods of Note Issue

Methods of note issue are the rules about what reserve (gold, foreign securities) the central bank must keep against the notes it issues. They balance two needs: public confidence and elasticity of money supply.

1. Fixed Fiduciary Method: the central bank may issue notes up to a fixed limit without any gold backing (backed only by government securities). This part is called the fiduciary issue (based on trust). Every note issued above this limit must be backed 100% by gold. It was started in England under the Bank Charter Act, 1844.

Merits: safe; high public confidence; over-issue is avoided. Demerits: inelastic — money supply cannot expand with trade; needs a large stock of gold; unsuitable for a developing country.

2. Proportional Reserve Method: the central bank must keep a fixed percentage of the total notes issued as reserve in gold and foreign securities; the rest is backed by government securities. India used it from 1935 to 1956: 40% of notes had to be backed by gold and foreign securities, with gold not less than ₹40 crore.

Merits: more elastic than the fiduciary method; reasonable confidence. Demerits: still needs a large reserve; expansion of currency is limited; a fall in reserves forces a cut in money supply.

3. Minimum Reserve Method: the central bank keeps only a fixed minimum amount of gold and foreign exchange, and can then issue any amount of notes. India adopted it in 1956 (minimum ₹515 crore, of which ₹400 crore foreign securities and ₹115 crore gold). In 1957 it was reduced to ₹200 crore, of which gold must be at least ₹115 crore; this is the system today.

Merits: highly elastic; suits a developing economy that needs more money for growth; saves foreign exchange. Demerits: risk of over-issue and inflation; depends on the discipline of the central bank and government.

Likely exam questions

1. (Long, 8/16 marks) Explain the evolution of money from the barter system to paper currency. What were the difficulties of barter?
2. (Long, 8/16 marks) What are the methods of note issue? Explain the fixed fiduciary, proportional reserve and minimum reserve methods. Which method is followed in India?
3. (Short, 4 marks) Explain the functions of money.
4. (Short, 4 marks) Explain the role and importance of paper currency.
5. (Short, 4 marks) Who is the note-issuing authority in India?

Syllabus topics (RTMNU)

• Meaning of Value of Money
• Measurement of Value of Money
• Quantity Theory of Money – Fisher’s Version
• Cambridge Quantity Theory of Money

Meaning of Value of Money

Value of money means the purchasing power of money — the quantity of goods and services that one unit of money (₹1) can buy. It is not the face value printed on the note.

Value of money and the general price level move in opposite directions: Value of money = 1 ÷ Price level (V_m = 1/P). When prices rise (inflation), the same ₹100 buys fewer goods, so the value of money falls; when prices fall (deflation), the value of money rises.

Types: (1) Internal value — purchasing power over goods inside the country; (2) External value — purchasing power over foreign goods, shown by the exchange rate (e.g. ₹ per US dollar).

Why it matters: a fall in the value of money hurts fixed-income groups (salaried people, pensioners) and creditors, while debtors and businessmen gain. Stable value of money is needed for savings, investment and planning.

Measurement of Value of Money (Index Numbers)

The value of money cannot be measured directly. It is measured indirectly through price index numbers, which show the change in the general price level compared with a base year (index = 100).

Steps in making a price index:

1. Decide the purpose (e.g. cost of living of industrial workers).
2. Select a base year — a normal year without unusual events.
3. Select a representative basket of goods.
4. Collect prices of these goods in the base year and the current year.
5. Give weights according to the importance of each item.
6. Calculate the index: Index = (Σ P₁Q₀ ÷ Σ P₀Q₀) × 100 (Laspeyres' method).
7. Value of money = 100 ÷ index number.

Illustration:

Index = (600 ÷ 500) × 100 = 120. Prices have risen by 20%. Value of money = 100 ÷ 120 = 0.83, i.e. ₹1 now buys only what about 83 paise bought in the base year.

Indices used in India: Consumer Price Index (CPI) — retail prices, published by the National Statistics Office (MoSPI); the RBI uses CPI (Combined) for its inflation target. Wholesale Price Index (WPI) — wholesale prices, published by the Office of the Economic Adviser, Ministry of Commerce and Industry.

Limitations of index numbers: difficult to choose a base year and basket; consumption habits change; quality changes are ignored; one index cannot suit all groups; data collection errors.

Quantity Theory of Money – Fisher's Version

Statement: Other things remaining the same, the price level varies directly and proportionately with the quantity of money, and the value of money varies inversely and proportionately. If money supply doubles, prices double and the value of money becomes half.

Equation of exchange (Irving Fisher, 1911, The Purchasing Power of Money): MV = PT. Including bank (credit) money: MV + M'V' = PT, so P = (MV + M'V') ÷ T.

• M = quantity of legal tender money
• V = velocity of circulation of money (times each rupee is used in a year)
• M' = bank (credit) money; V' = its velocity
• P = general price level
• T = total volume of transactions (goods and services)

Example: M = ₹1,000, V = 5, T = 5,000 units. P = (1,000 × 5) ÷ 5,000 = ₹1. If M doubles to ₹2,000 (V and T same), P = 10,000 ÷ 5,000 = ₹2. Prices double; value of money halves.

Assumptions: V and V' are constant; T is constant (full employment); the ratio of M' to M is constant; P is passive (an effect, not a cause); long-period analysis.

Criticism:

1. Truism: MV = PT is only an identity; it does not explain how prices change.
2. Unrealistic assumptions: V and T do change; full employment is rare.
3. Ignores the rate of interest and the demand for money.
4. Only long run: Keynes said, "In the long run we are all dead."
5. Ignores the store-of-value function of money.
6. Price level is not passive: prices can also affect money supply.

Cambridge Quantity Theory of Money (Cash Balance Approach)

Developed by Cambridge economists Alfred Marshall, A. C. Pigou, D. H. Robertson and J. M. Keynes. It explains the value of money through the demand for money to hold (cash balances), not through the money spent.

Basic idea: people keep a part (k) of their income in cash. If people want to hold more cash, they spend less, so prices fall and the value of money rises.

Equations:

• Marshall: M = kPY — M is money supply, k the proportion of income kept as cash, P the price level, Y real income.
• Pigou: P = kR ÷ M — here P stands for the value (purchasing power) of money, R is real income, k the part of it kept as cash; the price level is its inverse, M ÷ kR.
• Robertson: M = PkT, so P = M ÷ kT — T is total transactions.
• Keynes: n = pk — n is currency in circulation, p the price of a consumption unit, k the consumption units held as cash.

Superiority over Fisher's version: it stresses the demand for money and human behaviour; it is a short-run theory; it includes income, so it links to income theory; k (cash held) is more realistic than V; it laid the base for Keynes's liquidity preference theory.

Criticism: also assumes k and Y constant; ignores the speculative demand for money and the rate of interest; cannot explain trade cycles fully.

Likely exam questions

1. (Long, 8/16 marks) Explain Fisher's Quantity Theory of Money. Give its assumptions and criticism.
2. (Long, 8/16 marks) Explain the Cambridge cash balance approach to the value of money. How is it superior to Fisher's version?
3. (Short, 4 marks) What is meant by value of money? How is it related to the price level?
4. (Short, 4 marks) How are index numbers used to measure the value of money?
5. (Short, 4 marks) Distinguish between Fisher's and the Cambridge version of the quantity theory of money.

Syllabus topics (RTMNU)

• Inflation - Meaning, Nature, Causes, Effects, Impact and Remedies of Inflation
• Deflation - Meaning, Nature, Causes, Effects, Impact and Remedies of Deflation

Inflation: Meaning and Nature

Meaning: Inflation is a continuous and general rise in the price level over a period of time, which reduces the value (purchasing power) of money. A rise in the price of one item, like tomatoes in one week, is not inflation.

Definitions: Crowther — inflation is a state in which the value of money is falling, i.e. prices are rising. Coulborn — "too much money chasing too few goods".

Nature / features: persistent rise in prices; fall in value of money; a monetary phenomenon linked with excess demand or higher costs; measured by CPI or WPI; affects different groups differently; can be mild (helpful) or severe (harmful).

Types by speed:

Types by cause: demand-pull inflation (demand more than supply) and cost-push inflation (rise in cost of production). Also open vs suppressed inflation (prices held down by controls).

Causes of Inflation

A. Demand-pull factors (increase in demand):

1. Increase in money supply and bank credit.
2. Heavy government expenditure and deficit financing.
3. Rise in incomes and population.
4. Black money and hoarding.
5. Increase in exports, leaving less for the home market.

B. Cost-push / supply factors:

1. Rise in wages due to trade union pressure.
2. Rise in prices of crude oil, fuel and raw materials.
3. Higher indirect taxes.
4. Poor monsoon, crop failure and fall in agricultural output.
5. Supply chain problems, hoarding by traders, war and natural disasters.

Effects and Impact of Inflation

Impact on production: mild inflation encourages investment and output; high inflation creates uncertainty, speculation and hoarding, and diverts resources to unproductive uses.

Remedies of Inflation

1. Monetary measures (by RBI): raise the repo rate and bank rate; raise CRR and SLR; sell government securities through open market operations; selective credit control (higher margins on loans against stocks of goods). Since 2016, the RBI follows inflation targeting — CPI inflation of 4% with a band of ±2% — decided by the six-member Monetary Policy Committee.

2. Fiscal measures (by Government): cut unnecessary public expenditure; reduce deficit financing; raise direct taxes; encourage public savings and borrowing; cut indirect taxes on essential goods.

3. Other / direct measures: increase production, especially of food; import goods in short supply; price control and rationing; strengthen the public distribution system (PDS); stock limits and action against hoarding and black-marketing; control wages linked with productivity.

Deflation: Meaning and Nature

Meaning: Deflation is a continuous fall in the general price level, which raises the value of money. It is the opposite of inflation. Prices fall because demand is less than supply. Example: the Great Depression of 1929–33 in the USA and Europe, and the long period of low prices in Japan in the 1990s.

Nature / features: falling prices; rising value of money; falling production, income and employment; mostly linked with depression; a period of low demand. (Note: disinflation is only a fall in the rate of inflation; prices still rise, but slowly.)

Causes of Deflation

1. Fall in money supply and tight credit by banks.
2. Fall in government expenditure or a surplus budget.
3. Heavy taxation, which reduces purchasing power.
4. Fall in consumer demand and investment due to pessimism.
5. Over-production and excess capacity.
6. Fall in exports; high rate of interest; increase in savings (hoarding of money).

Effects and Impact of Deflation

1. Producers and businessmen lose: prices fall faster than costs; profits fall; firms close.
2. Unemployment rises as production is cut.
3. Fixed-income groups gain at first, as the same income buys more — but jobs become insecure.
4. Creditors gain, debtors lose: loans are repaid in money of higher value.
5. Farmers lose due to low crop prices.
6. Government revenue falls and welfare spending must rise.
7. Vicious circle: low prices → low profit → low output → unemployment → lower demand → still lower prices. Deflation is often considered more harmful than mild inflation.

Remedies of Deflation

Monetary measures: cut the repo rate and bank rate; reduce CRR and SLR; buy securities through open market operations to inject money; liberal and cheap credit.

Fiscal measures: increase public expenditure on infrastructure (roads, dams) to create jobs; reduce taxes; deficit budgeting; subsidies and relief packages.

Other measures: raise exports; support farm prices (Minimum Support Price); encourage consumption through schemes; public works programmes (like MGNREGA in India).

Likely exam questions

1. (Long, 8/16 marks) What is inflation? Explain its causes, effects and remedies.
2. (Long, 8/16 marks) Define deflation. Explain its causes and effects, and suggest measures to control it.
3. (Short, 4 marks) Distinguish between demand-pull and cost-push inflation.
4. (Short, 4 marks) Explain the effects of inflation on different sections of society.
5. (Short, 4 marks) Distinguish between inflation and deflation.

Syllabus topics (RTMNU)

• Money Market - Concept of Money Market
• Objectives
• Importance of Money Market
• Instruments of Money Market
• Monetary Policy and Fiscal Policy - Concept, Meaning, Objective, Need, Importance, Impact
• Recent Changes

Concept and Objectives of Money Market

Meaning: The money market is the market for short-term funds — borrowing and lending for a period of up to one year. It deals in "near money" instruments that can be turned into cash quickly. (Long-term funds are dealt in the capital market.)

Definition (RBI): the money market is the centre for dealings, mainly of a short-term character, in monetary assets; it meets the short-term needs of borrowers and gives liquidity to lenders.

Participants: RBI (leader and regulator), commercial banks, co-operative banks, financial institutions, mutual funds, NBFCs, large companies and the Government.

Structure in India: (1) Organised sector — RBI, banks, financial institutions; (2) Unorganised sector — moneylenders, indigenous bankers (shroffs, Multanis, Chettiars).

Objectives:

1. To provide a place for short-term borrowing and lending.
2. To use surplus funds of banks and companies profitably for a short time.
3. To help borrowers (government, firms) meet short-term needs at reasonable cost.
4. To maintain liquidity in the banking system.
5. To help the RBI carry out monetary policy.
6. To keep short-term interest rates stable.

Importance of Money Market

1. Finance for trade and industry: working capital through bills and commercial paper.
2. Profitable use of surplus funds by banks for even one day (call money).
3. Helps government borrow short-term through Treasury Bills.
4. Effective monetary policy: RBI changes the repo rate and liquidity, which passes through the money market to the whole economy.
5. Helps banks manage CRR and SLR needs without keeping idle cash.
6. Economic growth: mobilises savings and directs them to productive uses.
7. Signals the state of liquidity and interest rates in the economy.

Instruments of Money Market

Monetary Policy: Concept, Meaning, Objectives and Need

Meaning: Monetary policy is the policy of the central bank (RBI) to control the supply of money, availability of credit and rate of interest to achieve economic goals.

Objectives: price stability (control inflation); economic growth; full employment; exchange-rate stability; financial stability; proper flow of credit to priority sectors.

Instruments:

• Quantitative: repo rate, reverse repo rate, bank rate, Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), open market operations, Marginal Standing Facility (MSF), Standing Deposit Facility (SDF).
• Qualitative / selective: margin requirements, credit rationing, moral suasion, direct action, consumer credit regulation.

Need and importance: controls inflation and deflation; makes credit available for growth; supports agriculture, MSMEs and exports; protects the value of the rupee; keeps the banking system stable.

Impact: a tight (dear money) policy — higher repo rate, CRR — raises loan rates, reduces borrowing and demand, and brings prices down. An easy (cheap money) policy does the opposite and boosts investment and employment. Its limits: time lag, a large unorganised sector, and the influence of supply shocks like monsoon failure.

Fiscal Policy: Concept, Meaning, Objectives and Need

Meaning: Fiscal policy is the policy of the Government regarding taxation, public expenditure and public borrowing (debt) to achieve economic goals. It is presented every year through the Union Budget.

Instruments: taxation (direct and indirect), public expenditure, public debt, deficit financing, subsidies.

Objectives: economic growth; price stability; full employment; reduction of inequality in income and wealth; balanced regional development; mobilisation of resources for development.

Need and importance: builds infrastructure; helps during recession through more spending; controls inflation by cutting deficit; welfare schemes for the poor; encourages saving and investment through tax incentives.

Impact: higher spending and lower taxes (expansionary policy) raise demand, output and jobs, but may raise the fiscal deficit and prices; lower spending and higher taxes (contractionary policy) control inflation.

Recent Changes in Monetary and Fiscal Policy

Monetary policy:

• The RBI Act was amended in 2016 to give a statutory flexible inflation targeting framework: CPI inflation target of 4% with a band of 2% to 6%.
• A six-member Monetary Policy Committee (MPC) (three from RBI including the Governor, three appointed by the Government) decides the repo rate.
• The Standing Deposit Facility (SDF) was introduced in April 2022 as the floor of the liquidity corridor.
• Shift to digital payments: UPI growth and the pilot of the RBI's digital rupee (e-₹) from 2022.

Fiscal policy:

• FRBM Act 2003 for fiscal discipline and control of the fiscal deficit.
• GST from 1 July 2017, replacing many indirect taxes; GST rates were rationalised into fewer slabs in September 2025.
• Corporate tax cut in 2019 and a new income tax regime with lower rates (made the default from 2023-24).
• Large increase in government capital expenditure on roads, railways and infrastructure, and Direct Benefit Transfer (DBT) of subsidies.

Likely exam questions

1. (Long, 8/16 marks) What is money market? Explain its objectives, importance and instruments.
2. (Long, 8/16 marks) Define monetary policy and fiscal policy. Explain their objectives and compare the two.
3. (Short, 4 marks) Explain any three instruments of the money market.
4. (Short, 4 marks) State the main objectives of monetary policy.
5. (Short, 4 marks) Write a short note on recent changes in India's monetary or fiscal policy.