Grade 13 Economics: Money, Banking, and the Price Level

Definition and Characteristics of Money

Definition of Money: Money is anything that is generally accepted as a means of payment in the exchange of goods and services.
Historical Context:
- In the past, items such as sea shells and metal pieces were used as money.
- Some weaknesses existed in the process of money exchange during the past; these were eliminated with the use of present money.
Current Money Instruments: Present-day examples include coins, notes, cheques, treasury bills, debit cards, and credit cards.
Characteristics of Good Money:
- General Acceptance: Widely recognized as a valid medium of payment.
- Durability: Ability to withstand physical wear and tear over time.
- Uniformity: Different units of the same denomination must be identical in appearance and value.
- Divisibility: Can be divided into smaller units to facilitate various transaction sizes.
- Portability: Easy to carry around for transactions.
- Stability of Value: The purchasing power remains relatively constant over time.
- Legal Validity: Recognized by law as a valid means of settling debts.
- Difficulty to Counterfeit: Difficult to duplicate illegally.
- Easy Identification: Distinctive features that allow individuals to recognize it easily.

Functions of Money

Medium of Exchange:
- Acts as an intermediary during the exchange of goods, services, and production factors.
- This function allows money to be clearly identified from other assets.
- It eliminates the main difficulties of the barter system, specifically the absence of "double coincidence of wants."
- Double Coincidence of Wants: This refers to the mutual adjustment of the wants of both parties engaged in a transaction, which is necessary for barter but not for money-based exchange.
- The use of money as a medium of exchange allows for the expansion of division of labor and specialization, paving the way for large-scale production.
Store of Value (Store of Wealth):
- Money allows individuals to store value for future needs without risk or difficulty.
- Unlike goods, money does not face storage problems or perishing.
- Most persons use money to store value because of its perfect liquidity.
- Efficiency in this function depends on the maintenance of purchasing power at a constant level.
Unit of Account:
- Used to identify changes in the value of all goods, services, and assets.
- It makes the exchange process more efficient.
- Facilitates financial reporting, including business accounts, national accounts, government budgets, and the balance of payments.
Standard of Deferred Payment:
- The ability to settle past debts at a future date more efficiently.
- Used when firms sell goods on credit or financial institutions provide loans.
- A constant value of money ensures these payments are resettled without uncertainty or risk.

Types of Money used in the Present

Currency: Coins and notes issued by a financial authority that represent a certain value without internal value. It is legally valid within a country and possesses perfect liquidity.
Bank Money: The balance of demand deposits used to write cheques. This also possesses perfect liquidity.
Near Money: Highly liquid assets that act as a store of value but cannot act directly as a medium of exchange. They can be easily converted into a medium of exchange. Examples include:
- Fixed deposits
- Savings deposits
- Treasury bills
- Exchange bills
- Promissory notes
Money Substitutes: Instruments that act as a temporary medium of exchange but do not act as a store of value. Examples include credit cards and debit cards.
- Credit Card: An electronic card issued by a financial institution to buy goods and services at an approved limit or obtain money. Credit cards are not considered money because they do not fulfill all the activities of money, and use is restricted by a maximum credit limit which must be settled.
- Debit Card: An instrument used to withdraw money from ATMs or transfer money between accounts. They are not considered money as they do not perform all the activities of money.
Electronic Money / Digital Money: Money stored using an electronic system where transactions occur via software. Examples include E-Banking, easy cash, bitcoins, and transactions involving debit/credit cards.

Demand for Money (Liquidity Preference)

Definition: The preference of people to keep money in the form of money itself (cash or liquid form) during a given period.
Main Motives for Holding Money (Keynesian Approach):
1. Transactional Motive:
  - Holding money for day-to-day transactions due to the time gap between income receipt and expenditure.
  - Mainly depends on the income level ( $Y$ ).
  - The positive relationship is shown by: $\text{d}M_t = f(Y)$ .
2. Precautionary Motive:
  - Holding money for unexpected situations that cannot be planned, such as accidents or diseases.
  - Dependency on income ( $Y$ ) is positive.
  - The relationship is shown by: $\text{d}M_p = f(Y)$ .
3. Speculative Motive:
  - Demand for money to gain future benefits by investing in bonds; keeping money as an asset.
  - Selection between bonds and money depends on the interest rate ( $r$ ).
  - There is a negative (inverse) relationship between the interest rate and speculative demand for money: $\text{d}M_s = f(r)$ .
  - Relationship between interest rates and bond prices: When interest rates increase, the price of bonds decreases and vice-versa. If current rates are low (high bond prices), people expect rates to rise and bond prices to fall in the future, thus they hold less money and seek to purchase bonds later, decreasing current speculative demand.
Factors Affecting Demand for Money:
- Real Income: Direct relationship (Increases demand).
- Interest Rate: Negative relationship (Increases interest rates decrease demand).
- Price Level: Demand increases as price levels rise to maintain purchasing power.
- Future Expectations: Expectations of future inflation increase current money holding for goods; expectations of future security price increases decrease current money holding (as funds are shifted to securities).
- Institutional Factors: The time gap between income payments. Short gaps decrease demand; long gaps increase the amount of money held.
- Financial Market Innovations: Improvements in innovations generally decrease the amount of money held.

Money Supply

Definition: The total stock of money circulating among the general public at a given period, also known as the monetary aggregate.
Definitions of Money Supply in Sri Lanka:
- Narrow Money Supply ( $M_1$ ): Public currency ( $C_p$ ) and total demand deposits of the public with commercial banks ( $DD_p$ ).
  - $M_1 = C_p + DD_p$
- Broad Money Supply ( $M_2$ ): Sum of $M_1$ and savings and time deposits of the public with commercial banks ( $TSD_p$ ).
  - $M_2 = M_1 + TSD_p$
- Consolidated Broad Money Supply ( $M_{2b}$ ): Sum of $M_2$ plus 50% of time and saving deposits of non-resident foreign currency accounts ( $TsDNRFC$ ) and savings deposits of residents at foreign currency banking units ( $RDFCBU$ ).
  - $M_{2b} = M_2 + TsDNRFC + RDFCBU$
- Very Broad Money Supply ( $M_4$ ): Sum of $M_{2b}$ and time/savings deposits of the public with licensed specialized banks ( $LSB$ ) and registered financial companies ( $RFC$ ).
  - $M_4 = M_{2b} + LSB + RFC$
Determinants of Money Supply:
1. Net domestic assets of the banking system (Net lending to govt and private sector).
2. Net foreign assets of the banking system.
3. Other net assets.
Base Money (High Powered Money / Reserve Money): The direct financial liabilities that supply the basis for the aggregate money supply.
- Components ( $H$ ):
  - Notes and coins of the public ( $C_p$ ).
  - Currency of the public with commercial banks ( $C_{kb}$ , also referred to as vault cash).
  - Deposits of commercial banks with the central bank ( $RR$ , Required Reserves).
  - Deposits of other government institutions with the central bank ( $DOI$ ).
- Central Bank Balance Sheet for Base Money:
  - Liabilities: $C_p$ , $C_{kb}$ , $RR$ , $DOI$ , $D_{GCB}$ (Govt deposits), $F_{BCB}$ (Foreign loans), and other liabilities.
  - Assets: Loans of commercial banks ( $A_{KB}$ ), Loans to government ( $C_{GCB}$ ), International reserves ( $FA_{CB}$ ), and other assets.
Money Multiplier ( $k$ ): Shows the relationship between total money supply ( $M$ ) and base money ( $H$ ).
- $M = k \times H$
- $k = \frac{M}{H}$
- Example: $\text{Narrow money multiplier} = \frac{M_1}{\text{Base money}}$

Price Level and Inflation

Forms of Price:
- Absolute Price: Market price of a specific good (e.g., Rs. 25 for a pen).
- Relative Price: Ratio between prices (e.g., 1 kg rice is 4 times the price of a pen).
- General Price Level: Average value of absolute prices of all goods and services.
Inflation: Continuous increase in the General Price level.
Deflation: Continuous decrease in the General Price level.
Dis-inflation: Gradual decrease in the rate of inflation.
Theories of Inflation:
1. Demand-Pull Inflation: Increase in price level due to excess aggregate demand relative to supply ("too much money chasing too few goods").
  - Quantity Theory of Money (Fisher): Based on the Equation of Exchange ( $MV \equiv PT$ ). Assumes Velocity ( $V$ ) and Transactions ( $T$ or $Y$ ) are constant. Changes in $M$ lead to proportional changes in $P$ .
  - Keynesian Theory: Price level increases after the economy reaches macro-equilibrium at full employment ( $Y_1$ ) because supply cannot increase further despite rising demand.
2. Cost-Push Inflation: Increase in price level due to a decrease in aggregate supply caused by rising input prices.
  - Wages-Push: Pressure from organized labor for higher wages.
  - Profit-Push: Activities of oligopoly firms to maximize profits.
Consequences of Inflation:
- Unfavorable for fixed income earners (pensioners, office workers) as real income decreases.
- Formula: $\text{Real Income} = \frac{\text{Nominal income}}{\text{Price index}}$
- Unfavorable for lenders and savers; beneficial for borrowers.
- Reduces real interest rates: $\text{Real interest rate} = \text{Nominal interest rate} - \text{Inflation rate}$ . If negative, it is unfavorable for savers.
- Discourages long-term investment due to uncertainty.
- Causes Shoe Leather Costs and Menu Costs.
- Harmful for export competitiveness and lead to depreciation of the exchange rate.
Controlling Inflation:
- Limitation of Aggregate Demand (Fiscal and Monetary policy).
- Supply-side economics: Fast growth of aggregate supply (e.g., removal of taxes to incentivize production).
- Direct government intervention: Price control policies and income/wage limits.
- Elimination of barriers to efficient resource allocation (removing subsidies or rationing).

Price Indices in Sri Lanka

New Colombo Consumer Price Index (CCPI): Published by the Dept. of Census and Statistics. Base year is 2013. Coverage widened to all urban areas of Colombo District. Includes tobacco and narcotics.
National Consumer Price Index (NCPI): Covers all nine provinces. Base year is 2013 ( $2013 = 100$ ). Represents wider behavior across the whole country.
Producer’s Price Index (PPI): Introduced in 2015. Measures average prices received by domestic producers. Replaces the Wholesale Price Index.
GDP Deflator (Implicit Price Index): Measures change in current price levels relative to a base year.
- $\text{GDP Deflator} = \frac{\text{GDP at current prices}}{\text{GDP at constant prices}} \times 100$

The Financial System of Sri Lanka

Components: Financial institutions, Financial markets, Financial instruments, Financial infrastructures, and Regulatory bodies.
Institutions:
1. Central Bank of Sri Lanka: Established Aug 28, 1950, per the John Exter report. Objectives: Economic and Price Stability, Financial System Stability.
2. Intermediate Financial Institutions: Accept deposits (Banks) or manage funds (EPF, Insurance, Unit Trusts).
3. Financial Service Firms: Brokers, primary dealers, fund managers.
4. Supervisory Bodies: CBSL, Securities and Exchange Commission, Sri Lanka Insurance Board.
Financial Markets:
- Money Market (Short-term, < 1 year): Includes Inter-bank call money market, Treasury bills market, Commercial paper market, and Inter-bank foreign exchange market.
- Capital Market (Long-term): Treasury bonds, Corporate bonds, and the Share Market (Colombo Stock Exchange - CSE).
Financial Instruments: Treasury bills/bonds, Commercial papers, Debentures, Certificates of deposit, Business shares.
Credit Rating: Valuation of financial strength (e.g., Fitch Ratings, Moody's, Standard & Poor's).

Monetary Policy of the Central Bank

Framework: Moving towards Flexible Inflation Targeting (FIT) to keep mid-term inflation at single digits.
Quantitative Instruments:
1. Bank Rate: Interest rate charged to commercial banks as a lender of last resort.
2. Standing Deposit Facility Rate (SDFR) & Standing Lending Facility Rate (SLFR): Form an interest rate corridor for the call money market.
3. Statutory Reserve Ratio (SRR): Percentage of deposits banks must keep with the Central Bank.
4. Open Market Operations (OMO): Buying and selling securities to control money flow.
Qualitative Instruments: Credit limits, Moral suasion, collateral requirements.

Commercial Banks and Money Creation

Objectives: Maintaining Liquidity vs. Increasing Profitability. There is a controversy/trade-off between these two.
Balance Sheet Structure:
- Assets: Primary reserves (cash), Earning assets (T-bills, loans), Fixed assets.
- Liabilities: Capital, Deposits (Demand, Savings, Time), Borrowings.
Money Creation:
- Banks create money by lending excess reserves through the banking system.
- Deposit Multiplier ( $k$ ): $\frac{1}{r}$ (where $r$ is the SRR).
- Maximum Credit Creation: $\text{Initial Excess Reserves} \times \text{Deposit Multiplier}$ .
- Example: If SRR is 20% ( $0.2$ ), the multiplier is 5. An initial deposit of Rs. 10,000 creates Rs. 8,000 excess reserves. Total credit created = $8,000 \times 5 = 40,000$ . Total banking system deposits become Rs. 50,000.
Limitations on Money Creation: Cash leakage (public cash drain), banks keeping excess reserves beyond requirements, or insufficient demand for loans.