 Good morning, in the previous classes on economics I have told that the important measure that signals a strong or a weak economy lies in the wealth that a particular nation or economy is able to generate and while measuring the wealth the qualitative nature of growth lies in the output that the economy is able to generate. And that is why I was insisting that it is the output that actually measures the real wealth of an economy than just the circulation of money however that does not mean that money is not important it is that one particular form of wealth that is essential for any economy to function. So although output is more important than wealth in the study of macroeconomics we need to understand the importance of money because that is one particular form of wealth that actually ties together various macroeconomic variables. Let us understand why now if you ask the question why is that the study of money is very important there are a number of reasons for that. As I said before it is money that actually acts as the fuel for any economic activity and for the economic activity to grow or if an economic activity falls it is because either there is money or there is no money. So we must understand that it is the fuel that actually runs the economic engine. Now in the absence of money let us think how an economy will function. An economy functions because people and institutions buy goods and services, buy or sell goods and services and the transaction that involves the buying and selling gets complicated in the absence of money. Let us assume that there is no money in an economy and that I am a farmer and that I grow grain and once the cultivation period is over I will have to sell the grains then I will have to look for a purchaser who is willing to accept grains and in return give me something that is useful for my personal conception in the absence of money. So if I feel that at that point of time that I need furniture to build a house I am willing to give my grain to somebody who is willing to exchange grain in return for furniture. I need let us say some basic necessities for domestic survival. So I need to just look for somebody else who is willing to again accept the grain that I have in exchange of some of the domestic necessities that I need. So this form of exchange between products to secure an alternate product gets a little complicated it does not mean it is not possible but it is little complicated. Now we need to link all such products and services and facilitate a system in which a barter system that I explained before is replaced by an easy exchange of goods and services that can be purchased and sold by a common currency that a common unit in this case is money. So when we need to migrate from a barter system to a currency system everybody needs to accept one form of currency in exchange of goods and services. So I have grains with me I just sell it to somebody else who is ready to give me money for that and with that money I purchase furniture I purchase domestic supplies that I need for my domestic survival. So an exchange a migration from a complicated barter system wherein goods were sold and purchased by exchanging goods and services to a system where the same thing happens but in return it is the currency that gets transacted. As a result of which today we see every country has its own currency and it is that currency that is used to facilitate trade that facilitates the exchange of goods and services. And every country is currency the strength or weakness of a country's currency is measured against a universal currency and in today's perspective the US dollar is the universal currency. And there is a history to the emergence of US dollar as the universal currency I am not just going to go and explain but it is enough for you to understand that the US dollar is accepted as the universal currency against which every country's currency strength or weakness is measured relative to and if we need to import or export it is the dollar that acts as the common denominator. In fact after the world wars it was the American economy that actually took a great risk because we needed to have a common currency and the American government decided to pledge its entire gold reserves which actually if these gold reserves were reduced to a rope of half inch thickness it was enough to go around the world twice. So that is the extent of the gold reserve that the American government had at that point of time and then it decided to pledge the entire gold reserves to hedge the US dollar. So the US dollar at that point of time so for one ounce of gold 35 dollars was the equivalent amount. So that was the risk the American government took at that point of time to ensure that the US dollar is accepted as a global currency and anybody with gold let us say one ounce of gold if you give you get 35 dollars. So this is the history of how the US dollar gain significance as the global currency and of course after the Vietnam war and other economic activities then it was decided that no longer the American government could afford to pledge its gold reserves to maintain the relative strength of the US dollar it decided to take the gold reserves out and then came the Washington consensus and all these things that where the currency freely floating currencies of individual nations against the US dollar all of this happened but it is enough for you to understand that no longer was gold reserves protecting the American gold reserves was protecting the strength of the US dollar then in this free market economy it was the relative strength of each country's currency vis-a-vis the USD currency which is still the global currency that was the one that decided whether a particular country's currency is gaining strength or losing strength vis-a-vis the American dollar. Now let us get back to the discussion on money it is enough for you to understand that for global trade we need US dollars. Now I said the understanding of money is very important because the money affects many economic variables and I am going to just concentrate on three macroeconomic variables namely the interest rate the exchange rate and inflation how money affects these three macroeconomic variables because to me all these three in a way constitute the price of money that the cost of money let us see how let us begin with interest rate. Now interest rate a simple definition is cost of holding money or the cost of investment suppose I decide to put some deposit in a bank the return that I get is measured by the interest rate that the bank is willing to give on the deposit that I have with the bank or suppose I need to borrow money from the bank as a business the cost of borrowable is measured in terms of the interest rate based on which I will have to pay interest as an expense for borrowing the money from the bank this is the simple definition of interest rate but if you look at the conception of money now many would prefer receiving rupees hundred now than rupees the same rupees hundred one year from now as cash the reason is the value of money itself will change over a period of time and that is called the time value of money and now what decides the value of money is the interest rate today if I have 100 rupees I am not sure whether one year later the value of this 100 rupees is the same 100 whether it has increased or decreased depends on the prevailing interest rate and it is this interest rate that actually makes businesses or individual consumers to take decisions whether they need to borrow now to consume or borrow now to invest in a business if I have a business proposal in which I feel that the return on investment that I am going to get on the business proposal is more than the prevailing interest rates then I borrow and put that money in my business as a result of which I earned returns whose the return the returns is more than the interest rate so I am able to compensate for my interest expense so it is this interest rate that is actually the cost of money now if interest rate rises it means the cost of money rises it means money is getting expensive now if money is getting expensive then there is a direct impact on consumerism so I would not be borrowing more to engage in consumerism nor our business is interested in borrowing at higher costs as a result of which business investment drops so we need to understand that interest rate is one macroeconomic variable which is affected by the excess or the lower supply of money the second variable that we need to understand is the exchange rate as I said before it is the price of one particular currency with respect to another and as I said the US dollar is the global currency usually the strength of a currency is measured against the US dollar in this case let us for example say that the rupee dollar exchange rate is 50 which means for every dollar rupees 50 is the value now either a currency will strengthen or weaken against the US dollar it means either the currency appreciates or depreciates now for an economy an economy as I said before is an aggregate of different types of economic activities there is agriculture there is services there is industry and within this there is exports there is imports so the movements in the currency we saw with US dollar measured as whether it is depreciating or appreciating affects different economic players in different ways let us for example say understand what happens when a currency depreciates it means that if today the value of rupee against the dollar is like for a dollar as I said this 50 rupees and if the currency depreciates it means that the rupee is losing its value we saw with the US dollar now how is it going to affect different economic players it is good news for exporters because for every dollar of business that they export they are going to get more rupee denominated revenue because no longer is rupee 50 let us say it is 60 rupees so for every dollar exports instead of receiving 50 rupees there is a 60 rupees it is good news for foreign tourists who are coming here to India which means for a dollar that they give in return they get more Indian currency that they can spend on Indian soil but it is bad for importers because the foreign purchases now become expensive thereby it reduces the overall purchasing power which means today if I am paying 50 rupees for a dollar purchase I will have to shell out more it means I will have to pay 60 rupees for the same dollar purchase so if I am importing goods and services as a result of which a currency depreciation is bad news for importers now contrary to that if a currency appreciates then the exact opposite it is good news for importers suppose I want to go on a foreign vacation I need to purchase dollars which means I will have to pay less than 50 rupees to purchase one dollar if my currency appreciates so as somebody who wants to go on a foreign vacation it is good news for me so the fluctuations in the exchange rate because of which the domestic currency either loses or gains strength we survey the US dollar affects different business enterprises different economic activities in different ways it is it is based on who the economic entity is whether it is an exporter or an importer or a foreign tourist or an Indian who wants to go abroad on vacation so different stakeholders are affected different ways because of fluctuations in exchange rate and an exchange rate is again affected by money the third macroeconomic variable is the inflation now inflation at a very broad sense is the aggregate price level it is the average price of all goods and services it is not just price of one good it is a weighted average it measures inflation actually measures the weight if I say 6% what does it mean it means it measures the weighted average price rise of a basket of goods when compared to what it was before so it is this basket of goods that is actually the measure it actually the basket of goods and services that are included in calculating the weighted average price is symbolic of the nation's economy it could it would include housing it could include food prices medicine oil clothing all this so it is that price of goods and services which in terms of express in terms of money which either rises or goes down is measured by is actually inflation and if you look at a functioning economy a healthy economy you would find that price keeps changing all times sometimes the price may rise sometimes the price may fall sometimes price may rise for a particular commodities price may fall for certain set of commodities but if let us say there is a prevailing inflation in the economy then we would find across the board almost the price of all the goods and services will increase and if it is deflation likewise across the board the price of all the goods and services will fall now what happens to the value of money with price change I will just give you an example for you to understand let us say we I have a house whose values which I purchased 10 years back for 100,000 rupees 1 lakh and today the value of the houses 10 lakhs now people call this as the value of the house the houses remain the same it was I purchased it for 1 lakh 10 years back and today it is 10 lakhs the value appreciation in the house people take it as though the houses acquired some value actually it means that 10 years back with 1 lakh of rupees I was able to purchase this house and 10 years later with the same 1 lakh of rupees I am not able to purchase this house it essentially means that the purchasing power of the money has reduced it is of course it is people think that the value of the houses increased not disagreeing to that we must understand that with the same 1 lakh the purchasing power of the same house has reduced by one tenth which means the value of the money has reduced we will understand about this as we go further in understanding the concepts of inflation now there are actually two reasons for inflation one is the demand pull inflation at demand pull inflation is an inflation in which there is more demand than the supply typically such a situational arise when there is excess money supply due to a loose monetary supply due to a loose monetary policy I will explain what it is later but let us understand through a graph how the demand pull inflation can be explained suppose as I said before a demand pull inflation normally results from excess demand generated by a loose monetary policy where there is more supply less supply more demand so previously we know that our supply demand curve is like this so this is a price quantity and I am trying to explain the demand pull inflation and this is because of an increase in demand so notice that the demand has increased from D1 to D2 and inflation means rise in price so you notice that the price has increased from P1 to P2 so as demand shifts from D1 to D2 we notice that the price shifts from P1 to P2 with no change in supply because volumes cannot increase sufficiently to accommodate additional depend especially at a time when the economy is functioning at its maximum capacity so this is the this is an inflation that is called a demand pull inflation which is basically the demand is more than supply and it is because of the excess money supply and this demand additional demand is not being compensated by additional supplies because already the economy is at maximum capacity as a result of which the volumes cannot increase sufficiently to meet the increase in demand as a result of which you have noticed this price increase P1 to P2 so this is the demand pull inflation now just as we have demand pull inflation there is also another reason for inflation which is the cost push inflation again here in cost push inflation the prices increase I will again try to explain this using a graph so that you will understand that a cost push inflation is prices rise even when the economy is not operating at full capacity the reasons for that could be either due to a crop failure or currency devaluation or imports getting expense expensive or wage increases but there is no corresponding increase in productivity so these are all different reasons to for price increase as a result of cost push inflation because the economy is not at maximum but still prices keep increasing so what does that mean so I will just explain it again using a graph price quantity to explain cost push inflation so what happens here is demand supply for this one the support price is P1 Q1 let us say this is the new supply result of which P2 Q2 the product supply curve shifts upward due to higher cost and as a result of which this one drops because as cost increases the output that is produced will decrease because we cannot produce the same level of output at higher input cost and this is what you see in this graph as a result of which the output reduces and then that hits the demand curve at this price you will notice that P1 has increased from P2 this explains the cost push inflation which results in price increase as a result of as a result of increasing costs and at a time when not the economic activity is not at its full capacity now a demand pull if there is a demand pull inflation it is usually handled by a tighter fiscal and monetary policy that ready that that tries to control the availability of money and this we will understand when we talk about the fiscal and monetary policies a cost push inflation is handled by ensuring that there is either cost efficiency either you reduce the cost of inputs or increased productivity or try to produce more this is the way in which we will handle cost push now instead of resort resorting to such economically accepted ways of handling inflation there is also another method by which a direct intervention by the government through price controls can also be a temporary measure to address inflation here let us say this is the demand supply and this is to explain price control this is the existing price the government occasionally resorts to price control to prevent large price increases but price controls are basically as I told you temporary palliatives to price urges of products and commodities now if the government says this is the price at which things have to work then there is this supply gap because this is the quantity of supply this is the quantity it becomes the quantity demanded so price controls are short term and very counterproductive in a long term because they discourage production and version the gap between demand and supply but this is very rarely an accepted form of trying to combat inflation usually inflation is handled by a fiscal or a monetary policy or attempts to be more cost efficient and increase productivity so this is about inflation the next we know that money affects three variables as I said before the interest rate the exchange rate and inflation and I call that as the three prices of money one which is relative to time which is the interest rate the other it is relative to a foreign currency which is the exchange rate and a price that is relative to all goods and services that is the aggregate price level or the inflation now how the quantity of money affects all these three variables is an interesting subject matter of study we need to understand how excessive money or presence of limited amount of money affects interest rates exchange rate or aggregate price level or vice versa as well now let us first begin with interest rates now we need to understand that changes of money supply affects interest rate exchange rate and and the way in which it changes that is a complex subject of study by itself but I will just try to explain at a very very fundamental level as to how money supply increases if let us say money supply increases what happens to interest rates now suppose money supply increases the interest rate falls why it is just as if there is more number of goods what happens to the price of the goods it will fall down because a price of good will fall down if there is more of it available in the market likewise more money means the price of money in this case is an interest rate it will fall down let us say there is more oil in the global market the price of an oil barrel will fall down likewise if there is more amount of money in circulation then the cost at which you need to purchase the money will fall down if there is more money what happens to exchange rate let us let us understand the law of supply and demand to explain this let us for example say that there is a policy where for every automobile I am just taking an automobile industry to explain this how what happens to exchange rates let us say if every every car manufacturer supposed to source engine from a particular manufacturer in the US as a result of which the demand for that particular engine will keep on increasing if I need to purchase that particular engine from the US I will have to have enough US dollars to purchase that engine as a result of which the demand for the US dollar will increase so the US dollar will appreciate so what does it mean my currency will depreciate so this explains how the demand for the US dollar will cause a depreciation of other currencies relative to the US dollar the third thing is increased money supply is also inflationary what do I mean by that it means if there is more money more money without a proportionate increase in the output means more money is chasing the same amount of goods as a result of which there is price increase that is why I said increase in money supply is inflationary more money chasing fewer goods results to price increase so there is a standard relationship that we need to understand the relationship is if there is increase in money supply the interest rates will fall the exchange rate will depreciate or the price level will increase or in that is inflation and there is a symmetry in this relationship as a result of which the opposite the contrary is also true that is when there is a decrease in money supply you will find that the interest rate rises the exchange rate appreciates appreciates and price level falls it is called deflation so this is how there is a relationship between the supply of money and the interest rate exchange rate and inflation now let us dissect this to understand it better by beginning with interest rates now what do I mean by interest rate what you see in the newspaper what you see here in the news that is the nominal interest rate the rate that the bank quotes the rate that you see in the newspaper these are all nominal interest rates suppose the bank says that the cost of a loan is 5% it means the nominal rate of interest for the loan is 5% and now let us say inflation is 3% let us assume now the inflation is 3% now what will happen to the nominal interest rate it is 5 plus 3% I had explained this concept before when we were handling GDP it becomes 8% so the real interest rate is 5% only the real interest rate is 5% the resultant nominal interest rate is to cover the inflation of 3% I will just give you a small example for you to understand this let us say I am of there were two people and one wanted to borrow cows from the other now the understanding was I borrow 10 cows from somebody who was willing to lend me 10 cows and one year later I was prepared to give 11 cows in return so measured by way of the number of cows borrowed and returned the cost of this transaction was 10% because from 10 cows I had to return him 11 cows and this I did one year at the end of the year I gave back 11 cows and the cost of borrowing was 10% now next year also I wanted to do the same transaction but the difference was instead of cows I said I will borrow cash and return cash right so let us say the cost of one cow at the time of borrowing was rupees thousand which means I borrowed 10,000 and at the end of one year I had to give 11,000 because the cost of interest for the same borrowing was 10% now let us say during this period there was a price increase of let us say 10% and the cost of the cow at the end of one year was 1100 it was 1000 before and 1100 so during repayment time since I borrowed in cash and I have agreed to repay in cash I am repaying 11,000 rupees right now with this 11,000 rupees when I receive let us say I am the person who loaned out 10,000 rupees and at the end of one year I receive 11,000 rupees and with this 11,000 rupees if I decide to buy 10 cows how much will I have to spend I will have to spend the entire 11,000 reason the cost of the cow is no longer 1000 inflation has resulted in increase in the price of cow as a result of which now with the same 11,000 I can buy only 10 cows does it mean that there was no interest at all in this transaction it appears to be that is why we need to understand the effective real rate of interest the question is what should be the nominal interest rate to gain an effective real interest rate of 10% with regard to output and not the money the answer is a simple 21% how did I get this 21% this 21% is 10,000 is the principle plus an interest of 2100 which needs to cover the inflation as well as the real interest rate of 10% so only if I am compensated for inflation at an effective real rate of 21% would I say that this transaction is beneficial if you ignore this then the focus is on the nominal rates and not the real interest rate our focus should be on the real interest rate because it is output that actually matters and not money so in assessing the cost of borrowing the real rates is more important than the nominal rates but we need to understand that it is tough and then very ambiguous relationship between money growth and interest rate because let me just explain it using a small illustration the previous illustration was for you to understand that if the price of cows had increased by one-tenth then I would have to roughly double the nominal rate of interest to preserve a real rate of interest in terms of the cows of 10% now it is not as easy as things are explained that the money growth versus interest rate the relationship between money growth and interest rate is not as easy as it is theoretically understood if you look at the let us say increase in money supply normally when a bank increases the money supply short-term interest rates are expected to fall I am talking about nominal interest rates however growth in money supply particularly if it is substantial may also spark some inflationary expectations right inflation may rise because of this there is substantive increase in the money supply there is inflation and if inflation takes hold short-term nominal interest rates will eventually rise as well and because of these conflicting pressures the ultimate effect on the interest rate and money supply because of this large money supply if you need to understand the relationship it gets a little ambiguous because as explained before there is a pressure on the real interest rate real interest rates are very likely to fall so what happens to the nominal rate long-term nominal rates may fall rise or state is same depending on what happens to the inflationary expectations the this relationship is a little complicated because as I said before if there is an increase in money supply if you look at this if there is an increase in money supply short-term interest rates will fall and if there is more increase in the money supply the inflation will rise as a result of which if the short-term nominal interest should also have to rise and because of this conflicting pressures the ultimate effect on the nominal interest rates of a large increase in money supply is a little ambiguous now this is a little complicated subject to understand but we need to understand that the money supply and interest rates the relationship between money supply and interest rate is important for any macroeconomic decision making and the interest rate the rate at which the interest rate changes must also be understood from the perspective of the inflation because we are more interested in the real interest rate and now the nominal rate of interest as explained before in the examples of the cows the in assessing the cost of borrowing we should account for inflation because it is the real rate that is more important than the nominal rates now this is the first macroeconomic variable that is the interest rates the next class I will also discuss about the other macroeconomic variables namely the exchange rate and how the exchange rate behavior also changes with inflation just as interest rate behavior changes with inflation how exchange rate also changes with inflation thank you