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FAQ

The Bank and the Money Supply

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The narrowest measure Ml of the money supply is currency in circulation outside the banking system plus the sight deposits of commercial banks against, which the private sector can write cheques. Thus the money supply is partly a liability of the Bank (currency in private circulation) and partly a liability of commercial banks (checking accounts of the general public).

The Demand for Money

The demand for money is the quantity of liquid assets people are willing to have in hand at any given moment. It depends on the income they gain and the opportunity costs connected with the interest rate. But why do people hold money at all?

Money is a stock. It is the quantity of circulating currency and bank deposits held at any given time. Holding money is not the same as spending money when we buy a meal or go to the cinema. We hold money in order to spend it later.

The distinguishing feature of money is its use as a medium of exchange, for which it must also serve as a store of value. It is in these two functions of money that we must seek the reasons why people wish to hold it.

The Transactions Motive for holding money. In a monetary economy we use money to purchase goods and services and receive money in exchange for the goods and services we sell. Without money, making transactions by direct barter would be costly in time and effort. Holding money economizes on the time and effort involved in undertaking transactions. We need to hold

       
 

I. Theory of Supply.

II. Theory of Demand.

 

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Theory of Supply

The theory of supply is the theory of how much output firms choose to produce. The principal assumption of the supply theory is that the producer will maintain the level of output at which he maximizes his profit. Profit can be defined in terms of revenue and costs. Revenue is what the firm earns by selling goods or services in a given period such as a year. Costs are the expenses which are necessary for producing and selling goods or services during the period. Profit is the revenue from selling the output minus the costs of inputs used.

Costs should include opportunity costs of all resources used in production. Opportunity cost of a commodity is the amount obtained by an input in its best alternative use (best use elsewhere). In particular, costs include the owner's time and effort in running a business. Costs also include the opportunity cost of the financial capital used in the firm.

Aiming to get higher profits, firms obtain each output level as cheaply as possible. Firms choose the optimal output level to receive the highest profits. This decision can be described in terms of marginal cost and marginal revenue.

Marginal cost is the increase in total cost when one additional unit of output is produced.

Marginal revenue is the corresponding change in total revenue from selling one more unit of output.

As the individual firm has to be a price-taker1, each firm's marginal revenue is the prevailing market price. Profits are the highest at the output level at which marginal cost is equal to marginal revenue, that is, to the market price of the output. If profits are negative at this output level, the firm should close down.

An increase in marginal cost reduces output. A rise in marginal revenue increases output. The optimal quantity also depends on the output prices, as well as on the input costs. Of course the optimal supply quantity is affected by such non-economic factors as technology, environment, etc2.

Making economic forecasts, it is necessary to know the effect of a price change on the whole output rather than the supply of individual firms.

Market supply is defined in terms of the alternative quantities of a commodity all firms in a particular market offer as price varies and as all other factors are assumed constant.

1 to be a price-taker - .

2 etc. - ,

 
 
   
 

 
 

them to make financial plans for the future. For reasons such as these, some societies began to use another kind of money, that is, precious metals.

People used gold, gold bullion, as money. Those were dangerous times, and people wanted a safe place to keep their gold. So they deposited it with goldsmiths, people who worked with gold for jewellery and so on and also had a guarded vault to keep it safe in. And when people wanted some of their gold to pay for things with, they went and fetched it from the goldsmith.

Two developments turned these goldsmiths into bankers. The first was that people found it a lot easier to give the seller a letter than it was to fetch some gold and then physically hand it over to him. This letter transferred some of the gold they had at the goldsmith's to the seller. This letter we would nowadays call a cheque. And, of course, once these letters or cheques, became acceptable as a way of paying for goods, people felt that the gold they had deposited with the goldsmith, was just as good as gold in their own pockets. And as letters or cheques, were easier to carry around than gold, and a lot less dangerous, people started to say that their money holdings were what they had with them plus their deposits. So a system of deposits was started. The second development was that goldsmiths realized they had a great deal of unused gold lying in their vaults doing nothing. This development was actually of greater importance than the first.

Now let's turn to the first bank loan ever and see what happened. A firm asked a goldsmith for a loan. The goldsmith realized that some of the gold in his vault could be lent to the firm, and of course he asked the firm to pay it back later with a little interest. Of course, at that moment the goldsmith was short of gold, it wasn't actually his gold, but he reckoned it was unlikely that everyone who had deposited gold with him would want it back at the same time, at any rate - not before the firm had repaid him his gold with a little interest. He thought it safe enough.

 

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Fundamental to all financial markets is the idea of earning a return on money. Money has to work for its owner. Here are some of the ways it can do so:

1. You deposit $1,000 with a bank, which pays you, say, 10 per cent a year interest. In other words, your $1,000 of capital earns you $100 a year, which is the return on your money. When you want your $1,000 back you get $1,000, plus any accumulated interest, not more or less. Provided your bank does not go bust, your $1,000 of capital is not at risk, except from inflation, which may reduce its purchasing power each year.

2. You buy gold bullion to a value of $1,000 because you think the price of gold will rise. If the price of gold has risen by 20% after a year, you can sell your gold for $1,200. You have made a profit or a capital gain, of $200 on your capital outlay of $1,000. In other words you have a return of 20% on your money. If the price of gold fails to move, you've earned nothing because commodities like gold do not pay interest.

3. You use your $1,000 to buy securities that are traded on a

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IV. Theory of Supply.

 

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  1. One of my friends always asks me a lot of questions.
  2. I don't like this method, let's use another one.
  3. One economizes by buying large amounts of goods.


 

comparative rate of inflation is high may find that it is unable to compete in home or foreign markets because its products are expensive. The economic model tells us that a situation of declining exports and increasing imports will lower the level of activity in the economy with all the consequent side-effects.

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We would be simplifying the impact of inflation on business if we suggested that all effects were unfavourable. There is a school of thought, which argues that a low and stable rate of increase in the price level can be beneficial. It believes that a steady rise in money profits produces favourable expectations and induces investment as firms seek to expand. This action expands the economy as a whole. Paradoxically, inflation can also reduce the costs of businesses in the short run. Many enterprises incur costs, which are fixed for some period of time - for example, the rent of a factory may be fixed at a particular figure for a few years. At a time when the selling price of the firm's product, and hence its sales income, is rising this cost will be falling in real terms and thus stimulating the business.

There is a further argument that firms may be persuaded to borrow heavily in a period of inflation since the burden of repaying loans is reduced by inflation. If inflation is running annually at 10 per cent, for example, then the real value of the repayments of the loan will fall by approximately that amount each year. This may serve to encourage investment which, since it is an injection into the circular flow, will promote the level of activity. However, in these circumstances interest rates are likely to be high.

Government will accept that low rates of inflation are likely to exist in many economies. Inflation rates of 5 per cent or below are not considered to be too great a problem, especially if competitor nations are suffering similar rates.

In spite of the above, the conclusion must be drawn that inflation is, in general, harmful to business and its environment. Indeed, many economists would contend that inflation is the fundamental evil as its presence leads to lack of competitiveness and therefore relatively high unemployment and low rates of growth. This viewpoint has gained in credence in government circles over the last few years. It is for this reason that its control has been a major objective of government economic policy throughout the 1980s and early 1990s.

 

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The following story is going to explain the role of banks. In the past most societies used different objects as money. Some of these were valuable because they were rare and beautiful, others because they could be eaten or used. Early forms of money like these were used to buy goods. They were also used to pay for marriages, fines and debts. But although everyday objects were extremely practical kinds of cash in many ways, they had some disadvantages, too. For example, it was difficult to measure their value accurately, divide some of them into a wide range of amounts, keep some of them for a long time, use

       
 
  1. One should know the differences between these systems of marketing.
  2. One thing in which workers are different is human capital.
  3. It is one of the three leading elements of production.
  4. One can classify labour into productive and unproductive.
  5. The most general distinction is the one made between physical, financial and human capital.
  6. Economists consider a satisfactory lease to be the one that is profitable both for the landowner and the tenant.

10. A worker in the United Kingdom earns more than the one in India.

 

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  1. Firms can either save their income or pay it out to their owners.
  2. In comparing the national incomes it is not important which members of the population earn this income.
  3. It is economical to buy large quantities of a product rather that small quantities.
  4. Early economists said that that the value of product depended upon the amount of labour needed to produce it.
  5. The company is not large and it cannot invest much in production.
  6. It is the law of demand and supply that influences the retail price.
  7. It was our director who spoke about the losses of the company.
  8. It is essential that they keep accurate records of every transaction.
  9. It was the issued stocks that allowed our company to accumulate the necessary money for the new project.
  10. It is one of the three leading elements of production.

 

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margins.

 

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Inflation can adversely affect business in a number of ways:

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