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ECONOMICS FORM FIVE TOPIC 6: THE THEORY OF MONEY


 DETERMINANTS OF MONEY SUPPLY.

1. Printing more money by monitoring authority.

When the government undertakes run short of money, more money can be printed to finance them. This is called financed accommodation.

Demonetization is withdrawing all money in circulation reduces money supply.

2. Government borrowing from the central Bank.

When the central bank buys the securities (e.g. bonds) from the public money supply increases but when the central bank sells securities to the public, money supply is reduced.

3. Balance of payments (BOP) surplus when export exceeds imports the surplus foreign exchange for local currency such money circulates in the economy and the vice versa during balance of payment deficit.

Foreign capital inflow e.g. tourist who exchange foreign exchanges in local currency spends during their stay in the country and the vice versa during capital out flow.

4. Special deposits

If increased or if imposed by the central bank reduces money supply.

5. Credit by commercial banks.

This act by commercial banks using the cheque facility expands to result into greater volume of credit than the amount originally lend out. The increase in money supply in the currency.

This is the rate in which the central banks charge commercial banks from the loan given to them.

The increase interest rate to the public. The increase in interest rate will discourage borrowing and encourage saving hence decrease in supply and vice versa when the bank into decrease.

6. Selective credit control i.e.

If few factors get credit money supply reduces while of credit is not restricted money supply increase.

Refers to the continuous or persistent increase in the general price level of all commodities in an economy.

It can be increased by either NCPI (National consumer price index) or GDP (deflector) e.g. GDP defoliator
P-1 = Pt – 1= 1998=120.7
P-2= Pt = 1999 = 131.0

Inflation rate is defined simply as the velocity of the increase in general price levels and it is give by.

P = Inflation rate.

Types of inflation can be classified according to its causes and rate of spread or intensity.

Demands pull inflation.

Costs push inflation.

Others types of inflation are.

i) Imported.

ii) Structure.

Increase in aggregate demand from Do to DI leads to increase in price from Po to PI which is the inflation point.

CAUSES OF DEMAND PULL INFLATION:

1. Rapid increase in population.

The higher the population, the higher demand of goods and services.

2. Decrease in government taxes.

Lead to increase in personal disposable income which increases the purchasing power of an individual.

3. Increase in wages or income of an individual.

Increase in people income leads to increase in purchasing power.

4. Increase in government expenditure.

This will lead to increase in supply of money increased people will increases the rate of purchasing power which is in aggregate demand.

Increase in capital inflow thorough exports leading to increase in money supply.

Printing more money by the government through expansion of monetary policies.

Increase in exports of essential goods which leads to increase in foreign exchange hence more supply of money which increase aggregate demand.

Decrease in imports of essential goods which lead to increase in aggregate demand for such goods.

Decrease in output as a result of restriction by monopolist cause artificial shortage in an economy which will cause increase in demand for those goods.

MEASURE TO CONTROL DEMAND PULL INFLATION

Increase in taxation (direct) will reduce personal disposable income.

Production in government expenditure this will reduce supply of money in the economy.

Reduction in wages of workers.

Increase in importation of essential goods so as to reduce the problem of scarcity.

Use restrictive monetary policies i.e. Contraction monetary policies that reduce money supply in the economy.

Discourage rapid population pressure so as to reduce the demand for goods and services.

Encourages saving which will reduce aggregate goods demand.

COST PUSH INFLATION

Is the kind of inflation caused by increase in cost of production i.e. increase in wage, rent interest, also increased cost of equipments which can be used for production process.

From the graph increases in price of factors of production leads to the decrease in the supply of goods and services from Oyo to Oy.

CAUSES OF COST PUSH INFLATION.

High cost of raw materials especially those which are imported.

High advertising cost.

High wages to workers.

Trade units.

Increase in transport cost due to increase in price of fuel in the world market.

CLASSIFICATION OF INFLATION ACCORDING TO THE DEGREE OF INTENSITY. (SPEED)

1. Creeping or mild or gradual inflation.

This refers to the slow increase in general price level. The increase in the general price level is less than 3%. It encourages production and it does not distort relative prices or income severely.

2. Walking or trotting or moderate inflation.

This is where the increase in the general price level is a single digit or less than 10% per annual. It is a warning to the government to put measures to control it before it goes out of hand.

3. Running inflation.

This is when prices increases at the rate of 10 – 20 percent per year/annual. It requires strong measures to control it.

4. Hyper inflation or run away or Galloping inflation.

This is the rapid rise in the general price level where inflation ranges from 20% even more than 100% per annual.

Inflation becomes uncountable and prices rises many times every day. Money losses value and people prefer to hold real goods or assets than money.

OTHER FORMS OF INFLATION:

Wages – wages inflation.

This occurs due to inter firm or intersect or common wages among workers. A rise in wages in one sector or firm causes revision of wages in similar occupation in the economy. As enter preview increase wages total cost and prices also increases.

STRUCTURAL OR DEMAND SHIFT INFLATION:

This is occurring as a result of a combined element of cost push and demand pull inflation.

It occurs when there is a structure change in element of situation e.g.

In a situation where some industries are expanding while others are declining in the case of expanding industries higher wages has to be paid in order to attract labour increasing in wage cause inflation of a result of increase in cost of production.

Increase in production may result to the increase in demand for goods and services.

CAUSES OF STRUCTURAL INFLATION:

Temporary break down of economic sectors like agricultural sector and industry sectors.

Shortage of productive inputs i.e. if factors of production are in shortage. There will be low production in the economy hence aggregate demand being greater than aggregate supply.

Political instabilities. This will discourage production.

Speculation by business. This cause artificial shortage by holding their goods expecting that they will get more money in the future.

Shortage of foreign exchange to increase importation.

Poor transport system to reach goods in all parts of the country.

MEASURE TO CONTROL STRUCTURAL INFLATION

Improvement of transport system so as to enable goods and services to reach all parts of the country.

Modernization of agriculture as to improve agricultural activities.

Provision of productive input i.e. factors of production should be available in cheap price.

Creation of goods in a conducive atmosphere which promotes production.

Price control measures.i.e there should be price commission which will be responsible in setting minimum and maximum prices (price ceiling and price floor).

IMPORTED INFLATION

Is a type of inflation which is the result of imported goods and services from the country which is affect by inflation.

CAUSES OF IMPORTED INFLATION:

Importation of goods of high prices from countries experiences.

Rising prices in international market.

Import shortage.

Inelastic demand for imports.

Protection against imports i.e. through imports duties.

Expansionary / monetary policies which lead to high import demand.

EFFECTS OF INFLATION

1. Effects on production.

Production takes place in the two periods is short run plus long run period.

Effect of inflation in the short run.

In the short run increase in the price will encourage production because producer will sell their product at higher price.

At this period.

a. Wages or salaries cost adjust slowly.

b. Fixed charges such as result electricity, water supply and other charges adjust slowly.

c. Contacts and supply of raw materials covers long period until further orders are placed. The producer will use profit earned to increase production and possibly employment to stimulate demand.

2. Effect of inflation in the long run.

Inflation will discourage production as the money value falls hence all the cost of production will rise hence causing negative effects on production.

3. Effects of inflation in the long run.

Producers or profit earners.

4. These gain most during inflation as noted profit margin increase considerably during inflation but in short run only.

Wages and salary earners.

These also looses during inflation although not as much as fixed earners. Their loses will eventually be reduced due to wages and salary adjustment.

During inflation the value of savings falls i.e. rate fall this discourages saving and encourage wings.

Lenders

During inflation lenders tends to lose due to the fact that they are paid back their money when its value is low.

Social-political effects

Inflation has also effects on social and political affair to the economy such as;
• Crimes
• Unemployment.
• Political instability

EFFECTS OF INFLATION (GENERALLY)

Negative effects of inflation

Agriculturalists lose because prices of agricultural commodities tend to lay behind inflation. Their savings welfare and productivity falls.

Workers suffer when there is inflation because use wages kind to buy behind inflation.

The standard of living of fixed income consumers (like pension earners those who depends on past saving) falls.

It discourages people from saving in financial institutional because of fear that their money would lose value. Financial institution is forced to increase the rate of interest and this increases cost of borrowing and leads to further inflation.

It reduces the purchasing power of the majority since it redistributes income from the majority peasants and workers to the majority (business people).

Creditors lose because they are paid back in an inflation currency. This discourages lending by individuals and financial institution.

It leads to political unrest and demand for high salaries by workers. Therefore it increases people fail to meet the high cost of living e.t.c.

Inflation leads to balance of payment (BOP) problem of discouraging exports and encouraging imports. Exports reduce because dislike buying from a country where price are high. Import increase because outsides like to sell in a country where prices are higher.

Inflation may be used against the production of exports whose prices are determined on the world market. Prices remain fixed where as costs of production increase in the domestic currency. People shift to production for domestic markets to fetch higher price.

Where there is hyper inflation there is need to revise plan for tax structure and contacts to match with the new price structures. This is time consuming and can lead to fail are to archive objective of plans and programs.

Inflation to rural-urban migration since it becomes less profit to grow crops in rural area.

People shift to town to start businesses. This discourages agriculture in rural areas and lead to urban unemployment and development of slams in town.

It undermines the external value of the currency which calls for devaluation of the currency. This makes importation of raw materials difficult.

It leads to black market e.g. to create artificial shortages.

POSITIVE EFFECTS OF INFLATION:

Hyper inflation is ineducable in the economy. However mild inflation may be health to the economy in the following ways.

It increases the profit level of business (commercial producers) since cost of production rise lower than price of commodities. This encourages investments.

It makes workers and peasants to work harder to maintain their standard of living after the increase in prices which may provide incentives for people to encourage in economic activities.

It reduces the level of unemployment, since there would be a lot of money to spend and stimulate production and to invest and create more jobs.

It encourages business people to get loans since they would expect money to have lost value of the time of paying back.

It encourages people to produce goods to sell in the domestic market where price is high.

By encouraging urbanization it leads to an increase in demand for food which encourages agriculture.

POLICY FOR INFLATION

Policies for inflation are mainly macro economics policies which aim at stability. Efficiency and fair distribution of wealth. A policy of inflation depends on the causes of inflation. Policy instrument should reduce aggregate demand and increase supply.

A light (restrictive /ideas) monetary policy. This involve the use of various tools of monetary policy to reduce money supply and square consumption.eg increase in bank rates, selling securities to the public, increasing reverse rates etc. Produce money supply and aggregate demand at the extreme the government can also demonetize the currency by declaring the old one useless and new one.

Fiscal policy-This includes the reduction of government expenditure and increase of taxes to reduce aggregate demand. A supply budget where the government collects more revenue than its expenditure is a strong tool. The government can also do internal borrowing to reduce money supply and also postpone repayment of internal debts to the time when inflation is controlled.

Reorganization of distribution channel of goods–e.g. restoring of scarce commodities and rationalization of major distribution channel.

According to the kinked demand curve it does not pay for the oligopoly to the rise or lower price.

Depreciation and Appreciation of a Currency

Depreciation of a currency.

Is when there is a decrease in the value of the domestic currency in relation to the foreign currency purely caused by the market forces of demand and supply of the currency.

E.g. when it was1ksh. = 10Tshs.

And then it was 1ksh. = 20Tshs.

From the above example the Tanzania Tshs has depreciated.

Effects of depreciation of a currency

Increase in exports and they become cheaper.

Import decreases as they become more expensive

As exports increase and import decrease the deficit in the balance of payment reduces.

Depreciation stimulates more production and hence promotion of the domestic industries plus creating more employment opportunities.

Appreciation of the currency

This is when there is increase in the value of domestic currency in relation to the foreign currency purely caused by the market forces of demand and supply of the currency.

E.g.: when 1kshs was 10Tshs and then later on it was

1kshs was 6Tshs, so the Tanzania Tshs has appreciated

EFFECTS OF APPRECIATION OF A CURRENCY

Exports reduce as they become more expensive.

Import increase as they become cheaper.

As import increases and export reduces the deficit in the balance of payment increase results into the balance of payment problem.

Production contract and results into increase in unemployment

Value of Money

Value of Money is the purchasing power of money which is reflected through the amount of goods and services a cent of a currency can purchase.

Value of money can increase or decrease. For example during inflation, value of money decreases and during deflation the value of money increases.

Measuring changes in value of money

Changes in the value of money are measured through price index.

Price index is a figure which measure the relative changes in the price of various commodities from one period to another period. That is to say from the base to the current year.

NOTE: Price index can as well be called the cost of living index as it gives a picture on changes in the cost of living in a certain area from one period to another. Price indices can be producer’s price index, whole seller’s price index, retailer’s price index, etc.

TABLE SHOWS MEASURING CHANGES IN VALUE OF MONEY

Formula:

ΣPR=Price relative for each commodity
Σn=Total number of commodity
P1=Price in current year
P0=Price in the base year

Weighted Price Index

This is the price index which considers the weight assigned to various commodities and under this must important commodities are assigned high weights than those which are less important.

Commodity

Price in 1970(Shs)

Price in 1980 (Shs)

Price relative

A

20

25

125

B

5

10

200

C

15

30

200

D

40

50

125

E

200

450

225

Σn=5



Σ PR=875

Formula :WPI=Æ©WPR/Æ©W

Weight Price Index = 4450/24 = 185.4
185.4%-100%=85.4%
So the general price level increased by 85.4%

Lapser’s Price Index(LPI)

This is a base year weight price index therefore it uses the base year value as its weights.

This price index is a better way to get a picture on changes in the value of money, standard of living etc as it makes a comparison between the base and the current year.

LPI = Æ©PnQo/Æ©PoQo x 100
Where Æ© = summation
Po = Price in the base year
Pn = Price in the current year
Qo = Quantity in the base year

Commodity

weight

P x in1970

P x 1980

PR

W x PR

A

5

20

25

125

625

B

4

5

10

200

800

C

2

15

30

200

400

D

3

40

50

125

375

E

10

200

450

225

2250


Æ© = 24




Æ© = 4450

Interpretation

Price increased by 201%

Cost of living increased by 201%

Standard of living declined by 201%

Saving capacity declined by 201%

Pascal’s Price Index

This is a current year weight price index which is calculated by

PPI = Æ©PnQn /Æ©PnQox 100

Where

Æ© = Summation

Pn = Price in the Current year

Po = Price in the base year

Qn = Quantity in the current year

Using the precious table

PPI = Æ©PnQn/Æ©PnQox 100

Æ©PnQn = (4.0 x 2) + (1.5 x 10) + (25.0 x 1)+ (5.0 x 8) + (7.0 x 3)

= 8 + 15 + 25 + 40 + 21

= 109

Æ©PoQn = (3.2 x 2) + (2.0 x 10) + (5 x 0.1) + (1.0 x 8) + (1.0 x 3)

= 6.4 + 20 + 5 + 8 + 3

=42.4

PPI = 109/42.4 x 100%

PPI = 257.0754-100%

PPI ≈ 157%

Interpretation

Price increased by 157%

Cost of living increased by 157%

Standard of living decline by 157%

Saving capacity declined by 157%

Importance of Price Index

It is important in measuring changes in the general price level between the base and the current year therefore it is from the price index that it can be known whether the prices increase, reduce or remains the same.

Price indices are also important in knowing changes in the value of money over time. Therefore it can be known whether the value of money has increased or reduced.

Price indices are also important in measuring the cost of living between the base and the current year. Therefore it is from price index that it can be known whether the cost of living has increased or decreased.

Price index is also important in measuring in the standard of living between the base and the current year. Therefore it can be known whether the standard of living has increased or decreased.

Price indices are also important to the government and to the employees in the wage policy as it gives a picture on the cost of living and standard of living and hence creating a basic of wage revision.

Price indices are also important in measuring terms of trade, position of the country by use of the price index for export and price index for imports. Therefore price indices are important in showing changes in the terms of trade position of the country.

Price indices are also important in deflating National income from nominal to real through the use of the GDP deflation.

Price indices are also important in comparing the cost of living and standard of living between countries.

Problems experienced in measuring and use of price index

Choice of the base year

It is difficult to get a base year in which prices are relatively stable, this is due to the fact that they are normally ups and down in the prices.

Difficulty in selection of a common represent basket of commodity from the wide range of commodities.

The data problem.

It is difficult and unreliable data on prices and quantities as many consumers do not keep a record of their expenditures.

There are several ways/ methods that can be used to calculate price index but which give different answers this creates a problem in the interpretation.

Change in the prices may be as a result of improvement in quality which may be interpreted as inflation but which is not.

Index numbers have limited use for a long period of time due to the fact that taste and preferences change.

Steps taken in compiling price index.

Choice of an area where the data is to be collected

Choice of a common representative basket of commodities.

Collection of data on prices and quantities

Tabulation of the data

Choice of the appropriate formula and computation Interpretation


1998

2000


Items

Qty (Kgs)

P x (Shs)

Qty (Kgs)

P x (Shs)

Beans

2

3.2

2

40

Sugar

5

2.0

10

1.5

Meat

2

5.0

1

25.0

Rice

3

1.0

8

5.0

Maize flower

READ TOPIC 7

2

1.0

3

7.0

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