Unit 3: Money, Consumption and Investment Summary

Monetary Policy

Definition: Credit control measures by a country's central bank to influence the economy.

Definitions by:

  • Johnson: Utilizes central bank control of the money supply as a tool for economic policy to achieve macroeconomic stability.
  • G.K. Shaw: Refers to the actions by monetary authorities aimed at altering the quantity, availability, or cost of money in the economy to achieve certain objectives.

Objectives of Monetary Policy

  1. Full Employment: Aims to achieve a labor market where all individuals willing to work at prevailing wage rates can find employment, thus preventing wastage of potential output and preserving social standing.
  2. Price Stability: Maintains control over price level fluctuations, thereby reducing economic uncertainty and fostering a stable economic environment conducive to growth.
  3. Economic Growth: Focused on achieving rapid growth in real per capita income over time, improving living standards and economic prosperity.
  4. Balance of Payments: Strives for equilibrium in international economic transactions, helping to maintain a stable exchange rate and reduce vulnerability to external shocks.

Instruments of Monetary Policy

Types:

  • Quantitative Instruments (general/indirect): Affect the economy broadly via overall money supply adjustments.
  • Qualitative Instruments (selective/direct): Target specific sectors or types of credit within the economy.

Quantitative Instruments:

  • Bank Rate: The minimum lending rate set by the central bank for commercial banks. It increases during inflation to deter borrowing and cool off economic activity, while it decreases during recessions to encourage borrowing and stimulate the economy.
  • Open Market Operations: Involves buying or selling government securities to influence the reserves of commercial banks. Selling securities reduces bank reserves and lending capacity during inflation, while buying securities increases reserves during a recession.
  • Cash Reserve Ratio (CRR): Determines the minimum reserves each bank must hold against customer deposits. An increase in CRR restricts the amount of money available for lending, whereas a decrease permits more lending and credit extension.

Repo Rate:

  • A short-term borrowing rate for commercial banks from the central bank, which influences the lending rates across the economy. Raising the repo rate discourages borrowing by making funds more expensive, while lowering it encourages borrowing by making funds cheaper.

Money Supply Measures (RBI's Aggregates):

  1. M1: The sum of currency in circulation, demand deposits in commercial banks, and other liquid assets.
  2. M2: Combines M1 with savings deposits to provide a broader measure of money stock.
  3. M3: Includes M1 plus time deposits with commercial banks, offering an even wider measure of the money supply in the economy.
  4. M4: Encompasses M3 along with total deposits held in post office savings banks, reflecting the total monetary resources available in the economy.

Consumption Function

Definition: Describes the relationship between consumption expenditure and income.

Formula: C=a+bYC = a + bY where 'C' is total consumption, 'a' is autonomous consumption (consumption when income is zero), and 'b' is the marginal propensity to consume (MPC), representing the increase in consumption from an increase in income.

Attributes:

  • Average Propensity to Consume (APC): APC=CYAPC = \frac{C}{Y}, measuring the fraction of income spent on consumption.
  • Marginal Propensity to Consume (MPC): MPC=ΔCΔYMPC = \frac{\Delta C}{\Delta Y}, reflecting how consumption changes as income changes.

Determinants of the Consumption Function:

  1. Subjective Factors: Psychological traits and social practices that influence individual spending and consumption behavior.
  2. Objective Factors:
    • Changes in Wage Level: An increase in wages typically leads to higher consumption as households have more disposable income.
    • Fiscal Policy: Adjustments in taxation and government spending policies influence disposable income and thus affect consumption levels.
    • Expectations: Anticipations regarding future economic conditions (like income changes or job security) play a crucial role in current consumption decisions.

Investment

Definition: Refers to expenditures on new physical capital, such as machinery and buildings, rather than merely trading financial instruments.

Types:

  • Business Fixed Investment: Long-term investment in capital goods, such as new factories or machinery, that will be used over an extended period.
  • Inventory Investment: Involves the holding of stocks of raw materials and finished goods, reflecting changes in stock levels due to production and sales.

Determinants of Investment:

  • The expected profit rate relative to the prevailing market interest rate greatly influences investment decisions; if businesses anticipate a higher profit rate than the cost of borrowing (interest rate), they are more likely to invest in new capital assets.
  • Theory of Investment: The theory posits that an expectation of higher profits compared to interest rates motivates companies to engage in capital investment ventures