Why Study Money, Banking, and Financial Markets

•To examine how financial markets such as bond, stock and foreign exchange markets work

•To examine how financial institutions such as banks and insurance companies work

•To examine the role of money in the economy

1-3 Financial Markets

• Markets in which funds are transferred from people who have an excess of available funds to
people who have a shortage of funds

• Financial markets such as bond and stock markets are crucial to promoting greater economic
efficiency by channeling funds from people who do not have a productive use for them to those
who do.

• well-functioning financial markets are a key factor in producing high economic growth, and
poorly performing financial markets are one reason that many countries in the world remain
desperately poor.

• Activities in financial markets also have direct effects on personal wealth, the behavior of
businesses and consumers, and the cyclical performance of the economy.

 Financial markets, such as bond and stock markets, are crucial in our economy.
 These markets channel funds from savers to investors, thereby promoting economic
efficiency.
 Market activity affects personal wealth, the behaviour of business firms, and economy as
a whole

 Well-functioning financial markets, such as the bond market, stock market, and foreign
exchange market, are key factors in producing high economic growth.
 Financial Institutions are the institutions that make financial markets work

 “Financial Institutions are the intermediaries that take funds from the people who save
and lend it to people who have productive investment opportunities”.
 The Central Bank

The central bank has been described as "the lender of last resort," which means it is responsible
for providing its nation's economy with funds when commercial banks cannot cover a
supply shortage. In other words, the central bank prevents the country's banking system from
failing. However, the primary goal of central banks is to provide their countries' currencies with
price stability by controlling inflation. A central bank also acts as the regulatory authority of a
country's monetary policy and is the sole provider and printer of notes and coins in circulation.
Time has proved that the central bank can best function in these capacities by remaining
independent from government fiscal policy and therefore uninfluenced by the political concerns
of any regime. A central bank should also be completely divested of any commercial banking
interests.
The primary function of the central bank is to control the money supply in the economy. It is
responsible for issuing currency on behalf of the government. In addition to this primary
function, the central bank performs the following duties:
1. It receives the state revenues, keeps deposits of various departments and makes payments
on behalf of the government.
2. It keeps the cash reserves of the commercial banks, acts as a clearing-house for the inter-
bank transactions and as a lender of last resort. It supervises the commercial banking system
and ensures its smooth running.
3. It controls the money and capital markets by changing the supply of money and thereby the
rate of interest. The objective is to keep equilibrium in these markets.
4. It is the custodian of the foreign exchange. It has to keep a closer check on the external
value of the domestic currency and prevent its deterioration.
5. It is the adviser to the government in all the monetary affairs. It is responsible for the
formulation and implementation of the monetary policy.
The objective of the central bank is to ensure the internal and external stability of the currency.
Internal stability means keeping the purchasing power of the money intact and preventing its
deterioration. In other words, it has to maintain the rate of inflation within tolerable limits, if its
curtailment is not feasible altogether. External stability implies keeping a balance between export
and import or prevention of the foreign exchange value of domestic currency from depreciation.
In developing countries, the central bank is also concerned with the progress and development of
the economy. It provides financial support to various development programs of the government.
The central bank adopts various measures to control the money supply and commercial credit.
The bank exercises its authority via different instruments of credit control. We discuss these
measures very briefly.
Functions of a central bank may include:

 Implementing monetary policies.

 setting the official interest rate – used to manage both inflation and the country's exchange rate –
and ensuring that this rate takes effect via a variety of policy mechanisms
 controlling the nation's entire money supply
 the Government's banker and the bankers' bank ("lender of last resort")
 managing the country's foreign exchange and gold reserves and the Government bonds
 regulating and supervising the banking industry
The Commercial Banks
The commercial bank is an organized financial institution that deals with the business of credit
(borrowing and lending of money). The commercial banks are financial intermediaries between
savers and investors. Like other business firms, the main objective of commercial banks is to
earn profits. The bank accepts deposits from its customers and thus raises large funds that can be
loaned out. These may be in the form of demand deposit (readily available for checking: often
called current accounts on which the banks pay no interest), or time deposits (which can be
available only for business/loan extension). The saving deposits fall in between the two, which
can be withdrawn occasionally. The deposits accepted by a bank are its liability and the loan
extended to the clients as well as the bonds/shares of firms held by the bank constitute its assets.
The bank earns interest/profit on its investment a part of which is passed on to the depositors and
the remaining is appropriated.

The Process of Credit Creation

The commercial banks provide an easy medium of exchange in the form of checks, drafts, credit
cards etc. These are called bank notes or instruments of credit. These constitute a considerable
part of the total money supply in the economy. Anyhow, the banks cannot create money from
thin air; they convert physical wealth into liquid money. There must be an initial deposit with the
bank to start the process. Further, the power of the banks to create credit is limited by the reserve
requirements.

Commercial Banks: 7 Important Role of Commercial Banks in a Developing Country

Some of the major important role of commercial banks in a developing country are as

follows:
Besides performing the usual commercial banking functions, banks in developing countries play

an effective role in their economic development. The majority of people in such countries are
poor, unemployed and engaged in traditional agriculture.

There is acute shortage of capital. People lack initiative and enterprise. Means of transport are

undeveloped. Industry is depressed. The commercial banks help in overcoming these obstacles
and promoting economic development. The role of a commercial bank in a developing country is
discussed as under.

1. Mobilising Saving for Capital Formation:

The commercial banks help in mobilising savings through network of branch banking. People in

developing countries have low incomes but the banks induce them to save by introducing variety

of deposit schemes to suit the needs of individual depositors. They also mobilise idle savings of

the few rich. By mobilising savings, the banks channelise them into productive investments.
Thus they help in the capital formation of a developing country.

2. Financing Industry:
The commercial banks finance the industrial sector in a number of ways. They provide short-

term, medium-term and long-term loans to industry. In India they provide short-term loans.

Income of the Latin American countries like Guatemala, they advance medium-term loans for
one to three years. But in Korea, the commercial banks also advance long-term loans to industry.

In India, the commercial banks undertake short-term and medium-term financing of small scale

industries, and also provide hire- purchase finance. Besides, they underwrite the shares and

debentures of large scale industries. Thus they not only provide finance for industry but also help
in developing the capital market which is undeveloped in such countries.

3. Financing Trade:
The commercial banks help in financing both internal and external trade. The banks provide

loans to retailers and wholesalers to stock goods in which they deal. They also help in the

movement of goods from one place to another by providing all types of facilities such as

discounting and accepting bills of exchange, providing overdraft facilities, issuing drafts, etc.

Moreover, they finance both exports and imports of developing countries by providing foreign
exchange facilities to importers and exporters of goods.

4. Financing Agriculture:
The commercial banks help the large agricultural sector in developing countries in a number of

ways. They provide loans to traders in agricultural commodities. They open a network of

branches in rural areas to provide agricultural credit. They provide finance directly to

agriculturists for the marketing of their produce, for the modernisation and mechanisation of
their farms, for providing irrigation facilities, for developing land, etc.

They also provide financial assistance for animal husbandry, dairy farming, sheep breeding,

poultry farming, pisciculture and horticulture. The small and marginal farmers and landless

agricultural workers, artisans and petty shopkeepers in rural areas are provided financial

assistance through the regional rural banks in India. These regional rural banks operate under a

commercial bank. Thus the commercial banks meet the credit requirements of all types of rural
people.

5. Financing Consumer Activities

People in underdeveloped countries being poor and having low incomes do not possess sufficient

financial resources to buy durable consumer goods. The commercial banks advance loans to

consumers for the purchase of such items as houses, scooters, fans, refrigerators, etc. In this way,

they also help in raising the standard of living of the people in developing countries by providing
loans for consumptive activities.

6. Financing Employment Generating Activities:

The commercial banks finance employment generating activities in developing countries. They

provide loans for the education of young person’s studying in engineering, medical and other

vocational institutes of higher learning. They advance loans to young entrepreneurs, medical and

engineering graduates, and other technically trained persons in establishing their own business.

Such loan facilities are being provided by a number of commercial banks in India. Thus the

banks not only help inhuman capital formation but also in increasing entrepreneurial activities in
developing countries.
7. Help in Monetary Policy:
The commercial banks help the economic development of a country by faithfully following the

monetary policy of the central bank. In fact, the central bank depends upon the commercial

banks for the success of its policy of monetary management in keeping with requirements of a
developing economy.
 Securities and Exchange Commission

THE ROLE OF THE SEC

Mission

The U. S. Securities and Exchange Commission (SEC) has a three-part mission:

 Protect investors
 Maintain fair, orderly, and efficient markets
 Facilitate capital formation

The Securities and Exchange Commission (SEC) is the most well-known and feared governing
body in the financial world. Its very name can be intimidating to a small company hoping to go
public, but it doesn't have to be.

The SEC was established by Congress to regulate securities markets with the intent of protecting
investors. For this reason, it requires registration for the issuance of almost any kind of securities,
including mail or internet-based issues.

In an initial public offering, the process of filing necessary paperwork with the SEC can be time-
consuming and complicated. First, a registration for must be filed and declared effective. Despite
the fact that the registration becomes public knowledge immediately, the company may not
attempt to sell shares until the registration is declared effective. Registration documents include a
prospectus to be given to all investors, as well as a section that is made available on the SEC
website but which does not have to be provided to investors. A company's underwriter will
prepare and file these documents with the help of accountants and lawyers.

For a company that has gone public through an IPO, SEC requirements don't end with the
issuance of shares. Continued disclosures must be made concerning a variety of topics, including
details of operations, key employees and shareholders, major stock transactions, and general
health of the company. Because these disclosures are so numerous and frequent, there is a
substantial cost involved that should not be overlooked when making the decision to go public.
Despite the expense of SEC compliance, the cost of issuing stock would be higher without the
SEC. Because of SEC regulations, a large pool of information is available to potential investors.
Further, many otherwise unethical businesses are given good motivation to avoid
misrepresentation on company financial documents. This makes investing safer for everyone,
and allows investors to trade with less prejudice at higher prices.

For smaller businesses, the process of issuing shares is less complicated. Shortened forms and
procedures allow businesses seeking smaller amounts of capital to publicly sell shares without
the use of an underwriter. These rules also allow slightly reduced reporting requirements, as
compared to companies going public through an initial public offering. The overall effect is a
public issuance that costs significantly less than the traditional process for going public.

More recent SEC rules also allow for the public trading of direct public offerings issued by those
small companies. With the appropriate filings in place, small companies can apply to have their
shares traded on over-the-counter bulletin board exchanges, giving added liquidity to their
offerings. In this manner, the SEC has helped to encourage small business and innovation by
democratizing the availability of capital.

Despite the often negative opinions about the SEC and its requirements, it is an organization that
acts in the best interest of investors and for the overall good of the market. Proper attention and
diligence can ensure that an offering goes smoothly in spite of the inconvenience of necessary
filings.
The Fisher’s Quantity Theory of Money (Assumptions and Criticisms)
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The quantity theory of money states that the quantity of money is the main determinant of the

price level or the value of money. Any change in the quantity of money produces an exactly
proportionate change in the price level.

In the words of Irving Fisher, “Other things remaining unchanged, as the quantity of money in

circulation increases, the price level also increases in direct proportion and the value of money

decreases and vice versa.” If the quantity of money is doubled, the price level will also double

and the value of money will be one half. On the other hand, if the quantity of money is reduced
by one half, the price level will also be reduced by one half and the value of money will be twice.

Fisher has explained his theory in terms of his equation of exchange:

PT=MV+ M’ V’

Where P = price level, or 1 IP = the value of money;

M = the total quantity of legal tender money;

V = the velocity of circulation of M;

M’ – the total quantity of credit money;

V’ = the velocity of circulation of M;

T = the total amount of goods and services exchanged for money or transactions performed by
money.

This equation equates the demand for money (PT) to supply of money (MV=M’V). The total
volume of transactions multiplied by the price level (PT) represents the demand for money.
According to Fisher, PT is SPQ. In other words, price level (P) multiplied by quantity bought (Q)

by the community (S) gives the total demand for money. This equals the total supply of money in

the community consisting of the quantity of actual money M and its velocity of circulation V

plus the total quantity of credit money M’ and its velocity of circulation V’. Thus the total value

of purchases (PT) in a year is measured by MV+M’V’. Thus the equation of exchange is

PT=MV+M’V’. In order to find out the effect of the quantity of money on the price level or the
value of money, we write the equation as

P= MV+M’V’

Fisher points out the price level (P) (M+M’) provided the volume of tra remain unchanged. The

truth of this proposition is evident from the fact that if M and M’ are doubled, while V, V and T
remain constant, P is also doubled, but the value of money (1/P) is reduced to half.

Fisher’s quantity theory of money is explained with the help of Figure 65.1. (A) and (B). Panel A

of the figure shows the effect of changes in the quantity of money on the price level. To begin
with, when the quantity of money is M, the price level is P.
When the quantity of money is doubled to M2, the price level is also doubled to P2. Further,

when the quantity of money is increased four-fold to M4, the price level also increases by four

times to P4. This relationship is expressed by the curve P = f (M) from the origin at 45°.

In panel В of the figure, the inverse relation between the quantity of money and the value of

money is depicted where the value of money is taken on the vertical axis. When the quantity of

money is M1 the value of money is HP. But with the doubling of the quantity of money to M2,

the value of money becomes one-half of what it was before, 1/P2. And with the quantity of

money increasing by four-fold to M4, the value of money is reduced by 1/P4. This inverse

relationship between the quantity of money and the value of money is shown by downward

sloping curve 1/P = f (M).

Assumptions of the Theory:
Fisher’s theory is based on the following assumptions:

1. P is passive factor in the equation of exchange which is affected by the other factors.

2. The proportion of M’ to M remains constant.

3. V and V are assumed to be constant and are independent of changes in M and M’.

4. T also remains constant and is independent of other factors such as M, M, V and V.

5. It is assumed that the demand for money is proportional to the value of transactions.

6. The supply of money is assumed as an exogenously determined constant.

7. The theory is applicable in the long run.

8. It is based on the assumption of the existence of full employment in the economy.

Criticisms of the Theory:

The Fisherian quantity theory has been subjected to severe criticisms by economists.

1. Truism:
According to Keynes, “The quantity theory of money is a truism.” Fisher’s equation of exchange

is a simple truism because it states that the total quantity of money (MV+M’V’) paid for goods

and services must equal their value (PT). But it cannot be accepted today that a certain

percentage change in the quantity of money leads to the same percentage change in the price
level.

2. Other things not equal:

The direct and proportionate relation between quantity of money and price level in Fisher’s
equation is based on the assumption that “other things remain unchanged”. But in real life, V, V
and T are not constant. Moreover, they are not independent of M, M’ and P. Rather, all elements

in Fisher’s equation are interrelated and interdependent. For instance, a change in M may cause a
change in V.

Consequently, the price level may change more in proportion to a change in the quantity of

money. Similarly, a change in P may cause a change in M. Rise in the price level may necessitate

the issue of more money. Moreover, the volume of transactions T is also affected by changes in

P. When prices rise or fall, the volume of business transactions also rises or falls. Further, the

assumptions that the proportion M’ to M is constant, has not been borne out by facts. Not only

this, M and M’ are not independent of T. An increase in the volume of business transactions
requires an increase in the supply of money (M and M’).

3. Constants Relate to Different Time:

Prof. Halm criticises Fisher for multiplying M and V because M relates to a point of time and V

to a period of time. The former is a static concept and the latter a dynamic. It is therefore,
technically inconsistent to multiply two non-comparable factors.

4. Fails to Measure Value of Money:

Fisher’s equation does not measure the purchasing power of money but only cash transactions,

that is, the volume of business transactions of all kinds or what Fisher calls the volume of trade

in the community during a year. But the purchasing power of money (or value of money) relates

to transactions for the purchase of goods and services for consumption. Thus the quantity theory
fails to measure the value of money.

5. Weak Theory:
According to Crowther, the quantity theory is weak in many respects. First, it cannot explain

’why’ there are fluctuations in the price level in the short run. Second, it gives undue importance

to the price level as if changes in prices were the most critical and important phenomenon of the
economic system. Third, it places a misleading emphasis on the quantity of money as the
principal cause of changes in the price level during the trade cycle.

Prices may not rise despite increase in the quantity of money during depression; and they may

not decline with reduction in the quantity of money during boom. Further, low prices during

depression are not caused by shortage of quantity of money, and high prices during prosperity

are not caused by abundance of quantity of money. Thus, “the quantity theory is at best an
imperfect guide to the causes of the trade cycle in the short period” according to Crowther.

6. Neglects Interest Rate:

One of the main weaknesses of Fisher’s quantity theory of money is that it neglects the role of

the rate of interest as one of the causative factors between money and prices. Fisher’s equation of

exchange is related to an equilibrium situation in which rate of interest is independent of the

quantity of money.

7. Unrealistic Assumptions:
Keynes in his General Theory severely criticised the Fisherian quantity theory of money for its

unrealistic assumptions. First, the quantity theory of money for its unrealistic assumptions. First,

the quantity theory of money is unrealistic because it analyses the relation between M and P in

the long run. Thus it neglects the short run factors which influence this relationship. Second,

Fisher’s equation holds good under the assumption of full employment. But Keynes regards full

employment as a special situation. The general situation is one of the under-employment

equilibrium. Third, Keynes does not believe that the relationship between the quantity of money
and the price level is direct and proportional.

Rather, it is an indirect one via the rate of interest and the level of output. According to Keynes,

“So long as there is unemployment, output and employment will change in the same proportion

as the quantity of money, and when there is full employment, prices will change in the same
proportion as the quantity of money.” Thus Keynes integrated the theory of output with value
theory and monetary theory and criticised Fisher for dividing economics “into two compartments
with no doors and windows between the theory of value and theory of money and prices.”

8. V not Constant:
Further, Keynes pointed out that when there is underemployment equilibrium, the velocity of

circulation of money V is highly unstable and would change with changes in the stock of money

or money income. Thus it was unrealistic for Fisher to assume V to be constant and independent
of M.

9. Neglects Store of Value Function:

Another weakness of the quantity theory of money is that it concentrates on the supply of money

and assumes the demand for money to be constant. In order words, it neglects the store-of-value

function of money and considers only the medium-of-exchange function of money. Thus the
theory is one-sided.

10. Neglects Real Balance Effect:

Don Patinkin has critcised Fisher for failure to make use of the real balance effect, that is, the

real value of cash balances. A fall in the price level raises the real value of cash balances which
leads to increased spending and hence to rise in income, output and employment in the economy.

According to Patinkin, Fisher gives undue importance to the quantity of money and neglects the
role of real money balances.

11. Static:
Fisher’s theory is static in nature because of its unrealistic assumptions as long run, full
employment, etc. It is, therefore, not applicable to a modern dynamic economy.
The Fisherian approach has been severely criticised as under:

1. The equation of exchange is just a mathematical truism:

The equation of exchange by itself provides no analytical clue to the determinants of the value of
money. It says nothing about what determines what.

It is a mathematical identity, MV = PT, revealing that the turnover of money is always equal to
the turnover of goods, i.e., money paid equals money received. Hence, the cash transactions
equation is a truism or a self-evident proposition.

It is a statement of an obvious fact, because it states that money given in exchange for a good is
equal to its price or value. It does not state anything about money or prices, or does not indicate
which the cause is and which the effect is.

It indicates only the final stage of rise in the price level, but it does not explain the actual process
as to how an increase in the quantity of money influences the price level stage by stage.

In other words, the transactions theory only states the relationship between the quantity of money
and the price level, and it fails to explain the processes through which the quantity of money and
the price level is not so simple and direct as Fisher assumes, but it is a highly complex
phenomenon.

2. The price level (P) is wrongly assumed to be a passive factor:

The price level P is not passive as assumed by Fisher. In reality P may be active. P does
influence T, because rising prices give profit incentives to business expansion, T would increase.
Thus, a rise in P may increase the volume of trade which may cause an increase in the quantity of
money and V.

3. The velocity of circulation of money (V) may not be a constant factor:

Fisher regards V as independent and constant. But, in practice V may vary with the volume of
trade and price level, i.e., with P and T. V is also affected by the actual and expected changes in
M or money supply.

Then, the effect of changes in M may be neutralised by an opposite change in V. Sometimes, M

being constant, V may increase, causing the price level to rise. For instance, the hyperinflation in
Germany in 1923 was more as a result of the increase in the velocity of circulation rather than
the increase in the money supply.

4. The assumption of full employment in unrealistic:

A fundamental objection raised by Keynes against the cash transactions approach is that it is
based on the assumption of full employment, which is a rare possibility in a modern society.

When there are unemployed resources in the country, changes in M may not affect P as T also
changes. As long as there are unemployed resources, every increase in the money supply would
lead to an increase in real income or output.

But once full employment level is reached in the long period, the quantity of money will affect P.
The quantity theory, thus, becomes a limiting case which holds good in the state of full
employment only.

5. The equation of exchange has a technical inconsistency:

The significance of the equation of exchange in the theory is further reduced because it involves
a sort of technical inconsistency in using M and V. M refers to money at a point of time, whereas
V refers to the velocity of circulation over a period of time. Consequently, the extension of MV
involves the inconsistency of multiplying two non-comparable factors.

6. The ultimate determinants of the value of money lie behind the equation of exchange and
not in it:

According to Chandler, though M, V and T are assumed to be the immediate determinants of the
price level, they are in no sense its ultimate determinants. Instead, they are themselves
determined by a host of underlying objectives facts and human decisions.

Fisher has failed to go beyond the equation of exchange in examining the behaviour of the
ultimate determinants of the value of money. Following Chandler, we may enlist some of them
as under.

7. The Fisherian approach is mechanical and lacks human touch:

Fisher's explanation is mechanical, because the theory gives an impression that the price level
can be controlled by regulating the variables mentioned in the equation. In the equation, there is
no scope for the decision of consumers and producers about saving and investment.

The human element is absent in the equation. And money has no will of its own; so if money
supply increases, there is no guarantee that expenditure will also increase. In fact, it is' the
expenditure that determines the price level.

8. The transactions approach of the quantity theory of money is one-sided:

It considers the supply of money as the most effective, and assumes the demand for money to be
constant, thereby neglecting the forces of demand for money, causing changes in the value of
money.

Technically, the equation of exchange considered money only as a medium of exchange and
ignored its important function as a store of value. In other words, factors determining the demand
for money are not given due consideration.

9. The theory neglects the role of interest rate:

It is argued by critics like Mrs. Robinson that the quantity theory cannot be regarded as an
adequate theory of money because it does not take into account the rate of interest.

"Changes in the quantity of money are of utmost importance, but their importance lies in their
influence upon the rate of interest, and a theory of money which does not mention the rate of
interest, is not a theory at all," says Mrs. Robinson.

In fact, the relation between the quantity of money and the price level is indirect. An increase in
the supply of money reduces the interest rate which would encourage a greater investment
expenditure which along with the consumption expenditure would determine the price level.

10. Theoretical dichotomy into theory of money and the theory of value:

Keynes observed that the equation MV = PT artificially divorces the theory of money from the
general theory of value.

11. The Fisherian approach is static:

It is inapplicable to modern dynamic conditions.

12. The Equation of Exchange has a technical inconsistency:

As Prof. G.N. Halm points out, the expression MV in the question involves the inconsistency of
multiplying non-comparable factors such as M and V.

This is because, the stock of money M refers to a point of time; whereas, the velocity of
circulation V refers to the turnover of money during a period of time. Fisher, thus, illogically
multiplies a point concept (M) with a period concept (V).

Besides, the Fisherian version of quantity theory of money has been rejected on empirical
grounds also. Evidences simply do not corroborate the hypothesis that the price level varies
directly and proportionately with the quantity of money.

In fact, it has been noticed that the prices have risen even though there has been no change in
money supply; and prices have fallen (during a depression) Inspite of increased stock of money
and prices have moved upward, as in Indian economy, though the variation has not been in exact
proportion.

According to the more virulent critics, even if the prices and money stock were found to have
perfect positive correlation empirically, it cannot be accepted as a thesis that the variation in
money supply causes a proportional variation in price level at all times.