Monetary Policy

1. What is the importance of money?

Money has become so important that the modern economy is described as money
economy. Modern economy cannot work without money.

2. What is barter system?

Barter is the direct exchange of goods for goods. It is a system of trading
without the use of money

3. What is the function of money?

“Money is a matter of functions four: A medium, a measure, a standard, a

4. What is money?

Crowther, has defined money as “anything that is generally acceptable as a
means of exchange (i.e, as a means of settling debts) and that at the same
time acts as a measure and as a store of value”.

5. What is money as medium of exchange?

The most important function of money is that it acts as medium of exchange.
Money is accepted freely in exchange for all other goods. Barter system is
very inconvenient. So the introduction of money has got over the difficulty
of barter.

6. What is money as measure of value?

Money acts as a common measure of value. It is a unit of account and a
standard of measurement. Whenever we buy a good in the market we pay a
price for it in money. And price is nothing but value expressed in terms of
money. So we can measure the value of a good by the money we pay for it.
Just as we use yards and metres for measuring length and kilograms for
measuring weights, we use money for measuring the value of goods. It makes
economic calculations easy.

7. How is money store of value?

A man who wants to store his wealth in some convenient form will find money
admirably suitable for the purpose. It acts as a store of value. Suppose
the wealth of a man consists of a thousand cattle. It is rather difficult
for him to preserve his wealth in the form of cattle. But if there is
money, he can sell his cattle, get money for that and can store his wealth
in the form of money.

8. What is the role of money in standard of deferred payment?

Money is used as a standard for future (deferred) payments. It forms the
basis for credit transactions. Business in modern times is based on credit
to a large extent. This is facilitated by the existence of money. In
credit, since payment is made at a future date, there must be some medium
which will have as far as possible the same exchange power in the future as
at present. If credit transactions were to be carried on the basis of
commodities, there would be a lot of difficulties and it will affect trade.
Money, to be used as a medium of exchange, must be universally acceptable.

9. How are production, distribution and consumption influenced?

Production, distribution and consumption are influenced to a great extent
by prices, and prices are measured in money.

10. What are the components of money?

The Reserve Bank of India (RBI) is the central bank of our country. It
manages the monetary system of our country. It has classified the money
supply of our country into four components.

They are :

M1 = Currency with the public. It includes coins and currency notes +

deposits of the public. M1 is also known as narrow money ;

M2 = M1 + post office savings deposits ;

M3 = M1 + Time deposits of the public with the banks. M3 is also known as
broad money ; and

M4 = M3 + total post office deposits.

11. What is reserve money?

Reserve Money (RM) may be considered as Government money. Reserve money is
the cash held by the public and the banks. It is composed of

C = currency with the public in circulation

OD = other deposits of the public with the RBI (OD) (The public regard
their deposits

with the RBI as cash or money) and

CR = cash reserves of banks. Cash reserves are composed of two parts: –
They are

(1) Cash reserves with banks themselves and

(2) Bankers deposits with RBI.


Reserve Money (RM) = C+ OD + CR

12. What is fiat money?

Currency notes in circulation are normally referred to as fiat money. For
example, one Rupee notes issued by the Government of India is Fiat money.
The notes issued by the RBI are usually referred to as bank notes. They are
in the nature of promissory notes.

13. What is the main goals of monetary policy?

The basic goals of macroeconomic policy in most of the countries are full
employment, price stability, rapid economic growth, balance of payments
equilibrium and economic justice.

14. What is economic justice?

Economic justice refers to equitable distribution of income.

15. What is monetary policy?

“Monetary policy is policy that employs the central bank’s control over the
supply and cost of money as an instrument for achieving the objectives of
economic policy” (Edward Shapiro).

16. What are the instruments of monetary policy?

(1) Quantitative credit control measures ; and

(2) Selective credit control measures

17. What are the quantitative credit control measures?

Quantitative credit control instruments include bank rate policy, variation
of cash reserve ratios and open market operations.

18. What is bank rate?

The Bank rate is the minimum rate at which the central bank of a country
will lend money to all other banks.

19. What is variation of cash reserve ratio?

The ability of a commercial bank to create credit depends upon its cash
reserves. The central bank of a country has the power to vary the cash
reserve ratios. During inflation, to check the sharp rise in commodity
prices and to control credit, the central bank can make use of this weapon.

20. What are the factors that determine success of open market?

(1) The possession by the central bank of adequate volume of securities;

(2) The presence of well developed bill (securities) market; and

(3) Stability of cash reserve ratios maintained by commercial banks.

21. What are the weapons of selective credit controls?

The weapons of selective credit controls include

(a) Fixing minimum margin of lending or for purchase of securities. (For
example, shares or commodities like food grains and raw materials which are
in short supply). In this case, the central bank specifies the fraction of
the purchase price of securities that must be paid in cash. Unlike general
controls, selective controls make it possible for the central bank to
restrain what is regarded as an unhealthy expansion of credit. (eg. for
financing the purchase of securities or automobiles) ;

b) Ceiling on the amount of credit for expansion and

c) Different rates of interest will be charged to encourage certain sectors
and to discourage certain other sectors. In our country, the last weapon
has been used especially, to encourage exports, agricultural production and
production in small scale and cottage industries sector.

d) The central bank will persuade the commercial banks to follow certain
policies through moral suasion.

22.When was monetary policy ineffective?

Monetary policy is usually effective for controlling inflation. But during
the Great Depression of 1930s, it was found to be ineffective.

23. What are the two main conditions for success of credit control measure?

Two main conditions essential for the success of the credit policy are the
dependence of the money market upon commercial banks and dependence of the
commercial banks on the central bank for their funds.

24. What is money transmission?

The transmission mechanism tells that monetary policy affects income
through the interest rate and investment. It is the process by which money
supply affects income.

25. Why is money transmission narrow concept?

Many modern economists argue that this view of transmission mechanism is
rather narrow. They say that like investment, consumption may vary with the
interest rate. The classical economists assumed that consumption is
inversely related to the rate of interest. If we accept that view, a fall
in the interest rate will cause an increase in consumption. Since
consumption is a component of aggregate demand, aggregate demand increases.
This in turn, will increase the equilibrium level of income. If both
consumption and investment increase, income will increase by a greater
amount than if only investment increases.

26. What is net private wealth?

Net Private Wealth may be defined as society’s capital stock, money supply,
and government debt (government debt includes treasury bills, notes and
bonds). And consumption is positively related to net private wealth.

27. What happens if nominal money supply increases?

If the nominal money supply increases and price level is constant, the real
money supply increases. Since it is a component of net private wealth,
wealth increases, and in turn consumption increases. When consumption
increases, aggregate demand increases and the equilibrium level of income

28. What is dear money?

When there is inflation in a country, the central bank tries to control it
by following dear money policy. The term “Dear Money” refers to a phase or
policy when interest rates are high.’

29. What is cheap money?

Cheap Money” denotes a phase in which loans are available at low rates of
interest or a policy which creates this situation. Cheap money policy is
followed by a central bank during a period of depression to increase the
supply of money so as to stimulate investment.

30. What is value of money?

By “Value of Money” we mean the purchasing power of money. The purchasing
power of money depends upon the price level. A general rise in the price
level indicates a fall in the value of money and a general fall in prices
indicates a risen in the value of money.

31. What is quantity theory of money?

The Quantity Theory of Money was formulated by Irving Fisher. In its
original form, the quantity theory states, “prices always change in exact
proportion to changes in the quantity of money. If the amount of money is
doubled, prices double. If the amount of money is halved, prices fall to
half their original level”. The main point about the quantity theory is
that price level changes because of changes in the quantity of money.

32. What is equation of exchange?

The quantity theory of money has been put forward in the form of an
equation known as the “Equation of Exchange”. It is also known as Fisher’s
equation. The equation of exchange states that if ‘M’ is the amount of
money, ‘V’ is the velocity of circulation of money, ‘P’ is the price level
and ‘T’ is the volume of trade, then MV = PT (or P = MV/T).

33. What is inflation?

The terms ‘inflation’ and ‘deflation’ are not easy to define. Different
economists have defined them in different ways. Crowther has given us the
most simple and useful definition of these terms. According to Crowther,
“Inflation is a state in which the value of money is falling, i.e, prices
are rising”. So it is generally regarded that during a period of inflation,
the price level will rise.

34. What are the types of inflation?

1. Demand – Pull Inflation : It is loosely described as “too much money
chasing too few goods”. This refers to the situation where general price
level rises because the demand for goods and services exceeds the supply
available at the existing prices.

Runaway or Galloping or Hyper – Inflation

This is a serious type of inflation. For example, it was experienced in
Germany after World War I and in Hungary and China after World War II. In
this situation, prices rise to a very great extent at high speed and high
prices have to be paid even for cheap things. And money becomes quite
worthless and new currency has to be introduced. This situation is known as
galloping inflation or hyper-inflation.

2. Cost – Push Inflation

Cost – push inflation is induced by rising costs, including wages, so that
rising wages and other costs push up prices. We can also speak of wage
inflation or price inflation when we mean increase in wages or prices.

Bottleneck Inflation :
This refers to inflation that results from shortages, imbalances and rising
marginal costs as full employment output is approached. Profit – Push Inflation – Just as trade unions manage to push up
wages, oligopolists and monopolists will raise prices more than enough to
cover increase in costs with the aim of making monopoly profits.

35. What are the measures for inflation?

(1) Increased taxation

(2) By reducing government expenditure on capital projects. (In India, this
measure has been suggested to check inflation. Many capital projects
proposed in our Third Five Year Plan were either suspended or dropped

(3) Restrictions on imports.

(4) Rationing and

(5) Price controls

36. What is deflation?

Crowther, defines deflation as a “state in which the value of money is
rising, i.e., prices are falling”.

37. What are the effects of change in price?

1. Effects on production

If prices are rising, it will stimulate production. Under a capitalistic
system, production is carried on mainly for profits. During a period of
rising prices (inflation), there will be abnormal profits. This increases
production. So manufacturers and businessmen gain during inflation.
Producers and businessmen gain during inflation. Producers gain by
inflation because during that period prices rise faster than costs. So they
make huge profits. But if inflation becomes hyper-inflation, it may end in
a crash. On account of the rapid fall in the value of money, profits which
are in the form of money may become worthless. And there will be a “flight
from currency”. Inflation may become an important cause of “violent
revolutions and economic chaos”.

2. Effects on Distribution

a) Business class : During inflation, manufacturers and
businessmen make huge profits. Of course, during deflation, they make

b) Fixed income groups : People in fixed income groups are hit
hard in times of inflation. The incomes of wage earners and salaried people
such as teachers, clerks and judges do not increase as fast as prices. Even
retired people getting pension are also affected during inflation.

Wage earners and salaried – people gain during a period of falling prices.

But it is not a real gain because many people will lose their jobs during

Unemployment is a worse evil than rising prices.

c) Investors : people who have invested their money in “gilt
edged” securities government securities) will get only fixed income. So
their position is like those in the fixed income group. But those who have
shares in companies will make profits during a period of rising prices and
lose during a period of falling prices.

In Germany, thousands of middle class families were ruined during the
inflation because all their lifetime savings were reduced to nothing by the
tremendous rise in prices. If the value of money falls continuously, it
becomes unsuitable as a store of value. People will not save at all.

d) Rentiers : Rentiers gain during deflation and lose during
inflation. But the gain during deflation is only a temporary feature.

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