3.1]Concept of value of money

The value of money is its purchasing power, or the amount of goods and services that can be bought with a unit of money. The value of money is inversely proportional to the price level. In other words, as the price level rises, the value of money falls, and vice versa.

The value of money is also affected by the interest rate. A higher interest rate makes money more valuable, because it can be invested to earn a return. A lower interest rate makes money less valuable, because it earns a lower return.

Fisher’s transaction approach

Irving Fisher’s transaction approach to the value of money is based on the equation of exchange:

MV = PT

where:

• M is the quantity of money in circulation
• V is the velocity of circulation of money (the number of times a unit of money is exchanged in a given period of time)
• P is the price level
• T is the volume of transactions (the total value of goods and services exchanged in a given period of time)

According to Fisher, the value of money is determined by the quantity of money in circulation and the velocity of circulation. If the quantity of money increases, the value of money will fall. If the velocity of circulation increases, the value of money will also fall.

Keynesian cash balance approach

John Maynard Keynes’ cash balance approach to the value of money is based on the idea that people hold money for two reasons:

• To make transactions (transaction motive)
• To store value (precautionary motive)

The demand for money for transactions is determined by the volume of transactions. The demand for money for precautionary purposes is determined by the level of income and the interest rate.

According to Keynes, the value of money is determined by the supply of money and the demand for money. If the supply of money increases, the value of money will fall. If the demand for money increases, the value of money will rise.

Comparison of Fisher’s and Keynes’ approaches

Fisher’s transaction approach focuses on the supply side of money, while Keynes’ cash balance approach focuses on both the supply and demand sides of money. Fisher’s approach is more concerned with the short-run effects of changes in the money supply, while Keynes’ approach is more concerned with the long-run effects.

In general, Fisher’s approach is more useful for explaining changes in the price level, while Keynes’ approach is more useful for explaining changes in the interest rate.

3.2] Inflation and Deflation

Inflation

• Causes
  • Increase in money supply: When there is more money chasing the same amount of goods and services, prices tend to rise.
  • Demand-pull inflation: When aggregate demand exceeds aggregate supply, prices tend to rise.
  • Cost-push inflation: When the cost of production increases, businesses may pass on these costs to consumers in the form of higher prices.
  • Imported inflation: When the prices of imported goods and services increase, this can lead to inflation in the domestic economy.
• Effects
  • Erodes purchasing power: As prices rise, the amount of goods and services that can be purchased with a given amount of money decreases.
  • Redistributes wealth: Inflation can redistribute wealth from creditors to debtors, as the real value of debt declines as prices rise.
  • Discourages saving: As the purchasing power of money declines, people may be less likely to save.
  • Uncertainty: Inflation can create uncertainty in the economy, as businesses and consumers may be unsure about future prices.
• Control
  • Monetary policy: Central banks can use monetary policy to control inflation. For example, they can increase interest rates to slow down the growth of the money supply.
  • Fiscal policy: Governments can use fiscal policy to control inflation. For example, they can increase taxes to reduce aggregate demand.
  • Supply-side policies: Governments can implement supply-side policies to increase aggregate supply. For example, they can invest in education and infrastructure to improve productivity.

Deflation

• Causes
  • Decrease in money supply: When there is less money chasing the same amount of goods and services, prices tend to fall.
  • Demand-pull deflation: When aggregate demand falls below aggregate supply, prices tend to fall.
  • Debt deflation: When the burden of debt becomes too high, businesses and consumers may cut back on spending, leading to deflation.
  • Technological innovation: Technological innovation can lead to deflation by increasing productivity and reducing the cost of production.
• Effects
  • Increases purchasing power: As prices fall, the amount of goods and services that can be purchased with a given amount of money increases.
  •  Deflation can redistribute wealth from debtors to creditors, as the real value of debt increases as prices fall.
  • Encourages saving: As the purchasing power of money increases, people may be more likely to save.
  • Uncertainty: Deflation can create uncertainty in the economy, as businesses and consumers may be unsure about future prices.
• Control
  • Monetary policy: Central banks can use monetary policy to control deflation. For example, they can decrease interest rates to stimulate economic growth.
  • Fiscal policy: Governments can use fiscal policy to control deflation. For example, they can increase government spending to increase aggregate demand.
  • Supply-side policies: Governments can implement supply-side policies to reduce aggregate supply. For example, they can impose tariffs on imports to reduce competition from foreign producers.

3.3] Index Number

Meaning of index number

An index number is a statistical measure that is used to track changes in the value of a variable over time. Index numbers are commonly used to measure changes in prices, wages, production, and other economic variables.

For example, a price index number measures the change in the average price of a basket of goods and services over time. A wage index number measures the change in the average wage of a group of workers over time.

Index numbers are constructed by comparing the value of a variable in a given period to its value in a base period. The base period is a reference period that is used to compare changes over time.

Construction of simple index numbers

There are two main methods for constructing simple index numbers:

• Simple aggregative method: In this method, the prices of all the items in the basket of goods and services are added up for both the base period and the current period. The ratio of the total prices in the current period to the total prices in the base period is then multiplied by 100 to obtain the index number.
• Simple average of price relatives method: In this method, the price relative of each item in the basket of goods and services is calculated. The price relative is the ratio of the price of the item in the current period to its price in the base period. The average of the price relatives is then multiplied by 100 to obtain the index number.

Construction of weighted index numbers

Weighted index numbers are constructed by assigning weights to the different items in the basket of goods and services. The weights are typically based on the importance of the items in the basket. For example, the weight of a food item might be higher than the weight of a clothing item because food is a more important expenditure for most people.

There are two main methods for constructing weighted index numbers:

• Weighted aggregative method: In this method, the prices of all the items in the basket of goods and services are multiplied by their respective weights and then added up for both the base period and the current period. The ratio of the total weighted prices in the current period to the total weighted prices in the base period is then multiplied by 100 to obtain the index number.
• Weighted average of price relatives method: In this method, the price relative of each item in the basket of goods and services is calculated. The price relative is the ratio of the price of the item in the current period to its price in the base period. The price relatives are then multiplied by their respective weights and the products are added up. The sum is then divided by the sum of the weights to obtain the index number.

Comparison of simple and weighted index numbers

Simple index numbers do not take into account the importance of the different items in the basket of goods and services. As a result, they can be biased if the importance of the items changes over time.

Weighted index numbers take into account the importance of the different items in the basket of goods and services. As a result, they are less likely to be biased if the importance of the items changes over time.

In general, weighted index numbers are more accurate than simple index numbers. However, weighted index numbers require more information to construct than simple index numbers.

3.4] Importance of Index Number

Index numbers are a vital tool for measuring changes in a wide range of economic and social variables. They are used to track changes in prices, wages, production, and many other factors. Index numbers are used in a variety of ways, including:

• Measuring inflation and deflation: Index numbers of prices are used to measure changes in the cost of living. This information is used by governments and central banks to set monetary policy.
• Adjusting wages and salaries: Index numbers of wages are used to adjust wages and salaries for changes in the cost of living. This helps to ensure that workers’ purchasing power is maintained.
• Comparing economic performance: Index numbers can be used to compare the economic performance of different countries or regions. This information can be used by businesses to make investment decisions.
• Deflating economic data: Index numbers can be used to deflate economic data, such as GDP, for changes in prices. This helps to provide a more accurate picture of real economic growth.
• Forecasting economic activity: Index numbers can be used to forecast economic activity. For example, the Index of Leading Economic Indicators (LEI) is a composite index of 10 economic indicators that is used to forecast future changes in the economy.

In addition to these specific uses, index numbers are also used in a variety of other ways. For example, index numbers are used to measure changes in the quality of life, the level of poverty, and the environmental impact of economic activity.

Index numbers are a valuable tool for understanding and measuring changes in the economy and society. They are used by governments, businesses, and individuals to make informed decisions.

In summary, the importance of index numbers lies in their ability to:

• Provide a quantitative measure of change over time
• Facilitate comparisons between different periods, groups, or countries
• Allow for the deflation or inflation of economic data
• Serve as a basis for forecasting future economic activity

Index numbers are a versatile and indispensable tool for economic analysis.