Discuss different modes of creation of charges on securities

 Charging Securities: Bank tend to safeguard their advances by taking different kinds of securities .The main purpose of taking a security is to fall back on it in case the loan is defaulted. Bank take movable properties immovable properties or a debt as securities for a loan .The method of creating charge over a property depends upon the nature of property and nature of charge.

Bank charge over property confines itself to one or more of the following seven types of charges.

·         Hypothecation

·         Pledge

·         Assignment

·         Lien

·         Set-off

·         Mortgage

 

Hypothecation:

Hypothecation is a charge against property for an amount of debt where neither ownership nor possession is passed to the creditor. Though the borrower is an actual physical possession but the constructive possession remains with the bank as per ‘Deed of Hypothecation’. The borrower holds the possession not in his own right as owner of the goods but as the agent of the bank.

Features of Hypothecation

 

·         Charge against property for an amount of debt

·         Goods remain with the possession of the borrower

·         Ownership remains with the borrower

·         Borrower binds himself to give possession of the hypothecated goods to the bank when called up on to do so

·         It is a floating charge

·         It is rather precarious.

 

 

Pledge:

Pledge is said to be a bailment of goods as security for payment of a debt or performance of a promise. Pledged is the borrower who pledges the property and pledgee is the person with whom the property in pledged. Two important features of pledge are delivery of goods and return of goods.

 

Ownership of goods is not given and only possession over the goods is given, when goods are pledged. The pledger remains the owner of the property. This method is said to be very popular and simple in order to secure a charge on the property. The bank has the right to retain the security only in case of a particular debt for which goods are pledged.

Features of Pledge:

 

·         Goods bailed / pledged must be movable property (borrower)

·         Ownership remains with pledger (borrower)

·         Possession retains with pledgee (bank).

 

Assignment:

An assignment means a transfer by one person of a right, property or debt (existing or future) to another person. The person, who assigns is ’Assignor’ & to whom, is called ‘Assignee’. In banking the usual subject of assignment is “Actionable Claim”. It is permissible under sec.130 & 136 of Transfer of Property Act-1882 to assign “Actionable Claim” to anyone except to a          

(a)  Judge

(b)  A legal practitioner, &

(c)  An office of court of justice.

There are some defects on Assignment as security. So, Bank always creates Legal Assignment.

 Features of Legal Assignment

 ·         Must be in writing

·         Must be assigned by the assignor

·         Must be absolute

·         Notice is mandatory.

 

Lien:

Lien is the right of the Creditor in possession of the goods and securities belonging to a debtor, to retain them until a debt due from the latter is paid. (Sec-171 of Cont. Act-1872)

 

Presupposes: Before creation of charge Lien, the following conditions must be fulfilled:

 1)    Goods must be in the possession of the creditor in the ordinary course of business.

2)    Lawful debt.

3)    There must not have any contract to the contrary.

Types of Lien

 In terms of possession of security to the Creditor, Lien is of two types:

a) Particular Lien: - This is the right of the creditor to retain the particular commodity in respect of particular debt.

 b)    General Lien: - This is the right to retain goods & security not only in respect of particular debt incurred with the connection with them but in respect of general balance of account due by owner of the goods & securities, to the person in possession with them i.e. Creditor. The right of general lien is specially given by law to a) banker, b) wharfinger, c) Attorney of High Court, d)Factor & e) Policy broker     ( Contract Act-1872, sec-171).

 Features of General Lien:

 ·         Right for general balance,

·         Does not right to sell the property,

·         Simply the right to retain.

 Bankers lien is more then a general lien. Convention & legal decision have further extended the implication & scope of this right. In Brando vs. Barnett (1846) 12C1. And Fin.787, Lord Campbell stated that “Bankers have a general lien on all securities deposited with them as banker by customer, unless there be an expressed contract, inconsistent with lien. A bankers’ lien is more than a general lien; it is an implied pledge”.

  Set-off :

Set-off is combining accounts between a debtor & creditor as to arrive in net balance payable to one or other. Set-off means the total or partial merging of a claim of one person against another by counter claim by the latter against the former.

  Ingredients of Set-off

        i.   Mutual debt be for sums certain (two accounts of same persons)

      ii.   Debts to be due immediately

    iii.   Debts in same right

    iv.   No agreement to the contrary

      v.   Letter of Set-off Or Notice is required.

 

Automatic right of Set-off

 

(a)  On death, insanity or insolvency of the customer

(b)  On insolvency of a partner of a firm

(c)   On winding-up a company

(d)  On received a Garnishee order

(e)  On received a notice of assignment.

 

 

Mortgage:

A mortgage is the transfer of an interest in specific immovable property for the purpose of securing:-

 

1.    The payment of money advanced or to be advanced by way of loan

2.    An existing or future debt, or

3.    The performance of an engagement which may give raise to a pecuniary liability.  [T.P.act-1882 sec-58(a)]

 The transferor is called ‘Mortgagor’ & the transferee is called ‘Mortgagee’. The principal money & the interest of which payment is secured is called ‘Mortgage money’ & the instrument by which the transfer is effect called ‘Mortgage Deed’.

 Types of mortgage

1.    Simple Mortgage

2.    Mortgage by conditional sale

3.    Usufructuary mortgage

4.    English mortgage

5.    Equitable mortgage, &

6.    Anomalous mortgage.

What are the stages of credit management

 Stages of credit management are:

1.         Assessment of Borrowers data

2.         Sanction of the credit

3.         Documentation

4.         Disbursement of the credit

5.         Monitoring and supervision

6.         Recovery of disbursed loan

Two measures are taken

-Non Legal Measures

-Legal Measures.

Discuss different aspect of project appraisal

 Project Appraisal: Project appraisal is the process of analyzing the technical feasibility and economic viability of a project proposal their costs. Project appraisal enables to take a decision on with long term effects. During the appraisal stage, measurement of costs and benefits are difficult as these are spread over a long term with high degree of uncertainty. Different aspects of project appraisal are discussed as follows:

Technical Aspects:

Determines whether the technical parameters are soundly conceived, realistic and technically feasible. Technical feasibility analysis is the systematic gathering and analysis of the data pertaining to the technical inputs required and formation of conclusion there from. The availability of the raw materials, equipment, hard/software, power, sanitary and sewerage services, transportation facility, skilled man power, engineering facilities, maintenance, local people etc., depending on the type of project are coming under technical analysis. This feasibility analysis is very important since its significance lies in planning the exercises, documentation process, and risk minimization process and to get approval.

Checklist

- Physical scale

- Technology used & Type of equipment’s & Suitability conditions

- How realistic is the implementation schedule

- Labor intensive method or others

- Cost estimates of Engineering Data

- Escalation are taken care of or not

- Procurement arrangement

- Cost of operation & Maintenance

- Necessary raw material & Inputs

- Potential impact of project on human & physical Environment

-Location

-Size

-Process.

-Machines

-effluents and waste management

-availability of raw materials, power and other necessary inputs.

 

Financial Aspects:

 To determine whether the financial costs and returns are properly estimated and whether the project is financially viable? Whether prerequisites for the success of the project considered?    Following minimum details are determined in the financial appraisal;

1.      Total Cost

2.      O & M Expenditure

3.      Opportunity costs

4.      Other costs

5.      Returns on Investment over project life

6.      Net Present Value, Pay Back Period

7.      CBR 8. IRR

8.      Cash flows in the project

9.      Break Even Point. Level of risk

10.  Marketing Return expectation

 

 

Organizational Aspects:

To determine whether the implementing agencies as identified in the report are capable for effective implementation, monitoring, and evaluation of the scheme. Managerial competence, integrity, knowledge of the project, the promoters should have the knowledge and ability to plan, implement and operate the entire project effectively. The past record of the promoters is to be appraised to clarify their ability in handling the projects.

 

Checklist

·         Whether the entity is properly organized do the job

·         Strength to use capability and take initiatives to reach the objectives

·         Openness to new ideas and willingness to adopt long term approach to extend over several projects

 

Marketing Aspects:

It is one of the major areas of introducing of any product in market In that case must be considered this things before launching the product in the market.

·         What would be the aggregate demand of the proposed product of service?

·         What would be the market share of the project under appraisal?

 

Some popular issues in marketing appraisal are

·         Past and current demand trends

·         Past and current supply position

·         Production possibilities and constraints

·         Imports and exports

·         Nature of competition

·         Cost structure

·         Elasticity of demand

·         Consumer behavior such as motivation, attitudes, preferences, requirements etc.

·         Distribution channel

·         Marketing Policies

 

 

Environmental Aspects:

To see any detrimental environmental impacts and how to minimize the impacts. Environmental appraisal concerns with the impact of environment on the project. The factors include the water, air, land, sound, geographical location etc. Economic Appraisal How far the project contributes to the development of the sector, industrial development, social development, maximizing the growth of employment, etc. are kept in view while evaluating the economic feasibility of the project. Impact on quality of air, Water, Noise, Vegetation, human life etc. should be considered.

 

Legal Aspects:

To determine whether the project satisfies the legal issues related to land acquisition, title deed, environmental clearance etc.

 

Socio-Economic Aspects:

The economic feasibility basically deals with the marketability of the product. Basic data regarding demand and supply of a product in the domestic market so also marginal and also artificial.

Checklist

Socially acceptable technology.

Socio cost benefit analysis

Impact on level of savings and investment in society.

Impact of fulfillment of national goals such as Self-sufficiency, employment, social order etc.

discuss the internal and external factors affecting the change in attitudes towards bank marketing

 Every organization has to work within a framework of certain environmental forces and there is a continuous interaction between the organization and its environment. The interaction suggests a relationship between the two. This relationship can be analyzed in three ways.

First, the organization can be thought of as an input-output system. It takes various inputs-human, capital, technical-from the environment. These inputs are transformed to produce outputs-goods, services, profits-which are given back to the environment. Thus, the organization merely performs the function of input-output mediator. In this process, the environment in its interaction with the internal factors of the organization will determine what kind of inputs should be taken or outputs given.

Second, the organization can be taken as the central focus for realizing the contributions of many groups, both within and outside the organization. When these groups contribute to the well being of the organization, they must have a legitimate share in organizational outputs. These groups may be employees, consumers, suppliers, shareholders, movement, and the society in general. Thus, the organizational functioning will be affected by the expectations of these groups and the organization has to take these factors into account.

Third, the organization can be treated as operating in environment presenting opportunities and threats to it. Thus, how an organization can make the best use of the opportunities provided or threats imposed is a matter of prime concern for it. Any single approach by itself is insufficient to explain the complex relationship between the organizations and its environment Moreover, these approaches are not inconsistent to each other; they are complementary. Thus, an organization will be affected by the environment in which it works.

 The environment-organization interaction has a number of implications from strategic management point of view.

1. The environmental forces may affect different parts of the organization in different ways because different parts interact with their relevant external environment. For example, the technological environment may affect the organization’s R & D department. Further, these forces of the environment may have direct effect on some parts but indirect effect on others. For example, any change in the fiscal policy of government may affect the finance department directly but it may affect production and marketing indirectly because their program may be recasted in the light of new situation, though not necessarily.

2. The environmental influence process is quite complex because most things influence all other things. For example, many of the environmental forces may be interacting among themselves and making the impact on the organization quite complex. Moreover, the impact of these forces on the organization may not be quite deterministic because of interaction of several forces. For example, the organization structure will be determined on the basis of management philosophy and employee attitudes. But the organization structure becomes the source for determining the employee attitudes. Thus, there cannot be direct and simple cause-effect relationship rather much complexity is expected.

3. The organizational response to the environmental forces may not be quite obvious and identical for different organizations but these are subject to different internal forces. Thus, there is not only the different perception of the environmental forces but also their impact on the organization. Key factors determining responses to environmental impact may be managerial philosophy, life cycle of the organization, profitability, etc.

4. The impact of environmental forces on the organizations is not unilateral but the organizations may also affect the environment. However, since the individual organizations may not be able to put pressure on the environment, they often put the pressure collectively. Various associations of the organizations are generally formed to protect the interest of their members. The protection of interest certainly signifies the way to overcome unilateral impact of the environment on the organizations. The nature of organization-environment interaction is such that organizations, like human species or animals, must either adjust to the environment or perish.

Why consumers are placed at the Centre of marketing mix?

 Place is used to ensure that the product is relatively easy to purchase and is made available to consumers. And finally price should deliver “fair value” to consumers, based upon the array of benefits that they receive from purchasing the product.

Putting the customer first, in simple terms, means that a business puts the needs and requirements of a customer ahead of anything and everything else. They are oriented towards serving the client's needs, and measure customer-satisfaction levels in order to determine the success of their business.

Elements of Marketing, marketing approaches in financial services

 Elements of Marketing:

Marketing encompasses a number of different activities such as product design, pricing, strategies, advertising and others. However these are just activities which have to be done in the process of marketing. There are also some crucial elements of marketing which are very necessary for the success of marketing and they form the backbone of marketing. There four elements are as follows.

1) Research –  If you want to launch your own company or a product what will you do? The first thing that you will do will be market research. You will like to determine what the market actually wants. Similarly, during marketing too, market research is needed to determine what message should the company adopt and which medium will be best, what positioning needs to be achieved to target the right segment. By doing market research, we can gather data which can help us in analysis and action.

2) Strategy –  Once you have your data ready, you know where your product stands and also the standing of your company in the market in terms of strengths and weaknesses. You also have an idea of what strategies will need to be implemented and what factors will need to be adopted by the company to beat competitors and succeed in the market. Thus, after research, strategies decide the vision of the company, its goal, its mission and in general where the company wants to be. The strategic plan needs to be well thought of by realistically considering all possibilities.

3) Planning –  Now that you know, Where you want to be, naturally you have to plan How you are going to reach there. That is the job of the marketing planning department. The marketing plan involves sales forecasting, financial planning, communications strategy and many such benchmarks which define how the company is going to achieve its strategic goals in the future. The planning department also keeps a track of the timeline so that time to time we can determine whether we are on track with the strategic plan or not.

4) Tactics –  Where planning happens at the topmost level, tactics are the street smart, short term plans you implement to attract customers, beat your competitors, increase sales, provide a better value for your customers or for any other short term objective which needs to be achieved. Giving an offer such as “Buy 1, get 1 free” is a sales tactic. Lessening the price of your product during festival time is a promotional tactic. Several such tactics can be implemented by the company to make sure that it is inline with the planning done in the earlier stage. Some industries, such as FMCG and consumer durable, mainly survive on time to time tactics that the implement. Due to the competitive nature of these industries, smart tactics ar absolutely necessary to achieve good revenues and for customer acquisition.

Thus overall, there may be 100′s of marketing activities such as branding, advertising etc. But all these marketing activities are a part of the four key elements of marketing. Using these four key elements as base, you can compare where you stand currently, which department are you weak in and then plan your future accordingly

Explain the different steps in advertising for bank or financial services institutions

 Several steps are essential for successful execution of advertising campaigns in financial services.

Determining the Objectives of Advertising:

The first step is to determine the objectives of the advertising campaign, reflecting the overall marketing strategy of the company.

For example, the objective of an advertising campaign might be to generate new policies for an insurance product or to increase the level of consumer awareness of the brand or the company. Recognizing and identifying the exact objective of an ad campaign is critical to accurate assessment of its merits and potential. Examples of popular advertising objectives in financial services are target levels for customer inquiries, new policies signed, and advertising recall.

(2) Determining the available Budget

The next step in the advertising process is to determine the budget required to carry out the ad campaign. Often, the required budget is significantly different from what is available, and may be dictated by organizational budgetary constraints. For example, the budget available for advertising a particular financial service might be determined based on a percentage of the total premium revenues generated in the prior year. Clearly, an increase in the intensity of an advertising campaign would require higher budget allocations and may call for the abandoning of traditional budget-setting approaches for advertising. The total budget that is required to execute an advertising campaign is a function of the reach and frequency (and hence the gross rating points) necessary to create consumer response and the cost of media used to secure this level of exposure. The associated dollar figure, therefore, needs to have been estimated prior to negotiations with higher levels of management, in order to ensure the availability of sufficient funds for executing an effective advertising campaign.

(3) Estimating the Return on Investment (ROI):

The next step in the advertising process is to determine the return on investments associated with the advertising campaign. Four items of information are needed in order to conduct this estimation, one of which is an estimate of the lifetime value of an acquired customer. The lifetime value of the customer is the total profit that an acquired customer represents to the company. It is quantified as the sum of the profits associated with the stream of transactions that the customer will undertake with the company over the years. In addition, an estimate of the total number of consumers who will be exposed to the advertising campaign is required. An estimate of the percentage of reached consumers who will eventually purchase the advertised financial product or service is also required.  Clearly, negative return on investment estimates would make the advertising campaign and unlikely prospect for further action.

(4) Developing the Contents of the Ad:

Once the return on investment computation has shown favorable results, the next step in the advertising process is to develop the contents of the ad, as reflected in its execution style and informational content. In this step, the services of advertising agencies that specialize in producing financial services ads are required. These specialized agencies often also engage the support of legal experts who can determine the compliance of advertising content with existing regulations. Often, testing of ad content using small-scale samples, focus groups, or test markets may be needed.

(5) Media Selection:

The next step in the advertising process is to determine the media that will be used. In general, financial services that are more complex and require the communication of detailed information tend to rely on print forms of advertising.

Television advertising, which capitalizes on multiple sensory inputs, tends to be the most effective although often the most expensive. Once the media to be used for an ad campaign has been determined by the ad agency, a media schedule needs to be developed in order to achieve the original objectives of the ad campaign which had been identified. There are specific media scheduling and campaign execution strategies that are most effective in certain forms of financial services. For example, an effective ad-scheduling tactic is to advertise in pulses with heavy advertising in one month, reduced advertising the following month, and a return to high advertising levels in the third month.

(6) Scheduling and Campaign Execution:

There are specific media scheduling and campaign execution strategies that are most effective in certain forms of financial services. For example, an effective ad-scheduling tactic is to advertise in pulses with heavy advertising in one month, reduced advertising the following month, and a return to high advertising levels in the third month.

This tactic tends to result in more sales and higher levels of consumer response than a constant and steady level of ad spending.

(7) Measurement:

The final step in the advertising process is to assess the impact of the ad campaign through formal market research or examination of company records. It is critical to measure and record sales levels and other advertising responses following an ad campaign in order to determine the financial effects of the invested advertising dollars.

Such measures may help fine-tune the advertising strategy of the company and provide estimates for optimizing future advertising campaigns. For direct advertising campaigns, such measures are obtained through the tracking of consumer inquiries following the ad campaign and the use of tracking numbers, which can pinpoint the exact promotional material to which the consumers are reacting. For ads delivered through mass media such as television, radio, and newspapers, the tracking of consumer responses may be considerably more difficult and might require examining aggregate changes in sales for the months following the ad campaign, or the purchase of market research data from specialized research firms.

National Macroeconomic Goals

 In considering macroeconomic ‘good’ and ‘bad,’ consumption and investment expenditure are clearly in the ‘good’ column. Equally clearly, unemployment and inflation are in the ‘bad’ column. But other ‘goods’ and ‘bads’ exist which are less clear. Some amount of government expentiture is clearly good; government must at a minimum establish the rule of law, and deal with market failures such as public goods and externalities. However, a large spending defecit is generally considered a ‘bad.’ International trade is also generally a ‘good’ because it permits higher living standards than would be possible in a closed economy. However, it is not clear what the ideal balanace of trade would be. Would you prefer X>Z, a sign of strength like Japan or Germany, or Z>X, a higher use of foreign resources? Or would you prefer to maintain X=Z, resulting in a stable currency on foreign exchange markets?

 Having identified all the ‘good’ and ‘bad’ goals, we must now weight them. Since many of the ‘goods’ and ‘bads’ are interrelated, this will probably involve trade-offs. A political party’s election platform is an attempt to specify the weightings and tradeoffs considered most desirable. Consider the following ‘welfare function’ where W is national welfare (similar to individual utility from microeconomics):

 W = C^0.6I^0.2G^0.2 –U² –INF³ – 10|G-T|

 This states that C, I and G are all ‘good’ but the optimum distribution between them is 60% C, 20% I and 20% G; that unemployment is a ‘bad’ but inflation is worse, and that an unbalanced budget is a ‘bad’ no matter which direction it is unbalanced. To maximize W, the naïve answer is to make GNP as large as possible, allocate GNP among C, I and G in 3/1/1 ratio, have a zero unemployment rate, a zero inflation rate and a balanced budget. This interpretation is naïve because a zero unemployment rate is not possible, and U and INF are interdependent; some difficult calculations must be performed to determine the optimal rate of both U and INF on a given Phillips curve (assuming you believe a Phillips curve exists). The trade-off is also not simply between U and INF. The higher U, the lower GNP, hence the lower C, I and G as well. And whatever actions you take may result in an unbalanced budget, with its own effect on the equation. Balancing the budget is, for all the obvious reasons, neither simple nor easy.

 Also, strange interactions may exist that are not obvious at first. Suppose a balanced budget is a priority and the only apparent way to achieve this is to raise taxes. Some economists believe in the Laffer Curve:

  Laffer’s argument is that if the income tax rate were 100%, nobody would be willing to work since all wages and salaries would go in taxes; government tax revenue would therefore be zero. As tax rates decreased, some people would begin to work and tax revenues would increase, to some maximum at some point; below that point, decreasing tax rates would begin to result in decreased revenues, again reaching zero when the tax rate is zero. Some tax rate X exists where maximum revenue is achieved. If the government is already taxing at this rate, any change, positive or negative will result in reduced revenues. Moreover, if the government is already taxing above this rate, an increase in tax rates will be accompanied by a decrease in revenues; the budget-balancing action in this case would be to reduce tax rates. Hence Reaganomics and ‘voodoo economics.’ If you believe in the Laffer curve, then any increase or decrease in the tax rate must be based on a good estimate of where the economy is currently positioned.

 Another problem is that if you are trying to maximize the sum of national welfare across a span of years, then maximizing welfare this year might not be the correct approach; some less-than-maximal value for W this year might lead to the potential for higher values for W in future years than would otherwise have been possible.

 Different political parties believe in different national welfare functions; the items in these functions are generally similar but the weightings are radically different. Evidence suggests that the state of an economy is a major factor in deciding which party gets elected, and as a result elected governments may enact policies to ‘solve’ economic problems in election years, regardless of what problems may be caused down the road.

The Keynesian Theory of Money

 Where the quantity theory treats money exclusively as a medium of exchange, they Keynesian theory stresses that money serves other functions as well. There are three types of demand for money balances:

·         The transactions demand,  which arises from the fact that people need money to finance current transactions. Households and firms hold money balances to bridge the gap between the reciept of income and its expenditure. The amount of money held for such purposes will be closely related to the level of national income. However, it is also likely to be influenced by the rate of interest. If the rate of interest is high, there will be a strong motive to avoid holding money and instead hold interest bearing assets.

·         The precautionary demand, which consists of money to be held to meet the sudden arrival of unforseen circumstances. Again, the main factor likely to influence this amount is the level of income, though again high interest rates will tend to push money out of this category.

·         The speculative demand, which emphasizes the use of money as a store of wealth rather than a medium of exchange. Holding money has an opportunity cost: The income or utility foregone on the investments or goods the money could have bought. Therefore it would seem that households and firms ought immediately to invest or spend all money above that required for transactional and precautionary needs. However, in the presence of uncertainty, individuals or firms will sometimes believe that the returns available in the future might be sufficiently better than the returns available today that it is worth waiting.

 The speculative demand bears further analysis. While there will be speculation on all goods and services whose price can change with time, the speculative demand is particularly interesting in the market for government bonds. If households and firms believe the price of bonds will fall in the near future, they will be likely to sell their current holdings of bonds and to defer purchasing new bonds until the price drop has taken place. These actions increase the supply and reduce the demand for bonds on the open market, which will have the effect of lowering their price. Under this situation, the speculative demand for money will be high as households and firms will wish to hold money in anticipation of the price drop. Conversely, if households and firms expect bond prices to rise, then they will defer selling bonds now and, if they have money available, will tend to want to buy bonds. This will decrease the supply and increase the demand for bonds, driving prices up; and the speculative demand for money will be low, because speculative monies will tend to be invested in bonds.

 The price of government bonds and the interest rate are inversely and tightly related. Suppose that an individual is considering the purchase of a government bond which pays $10 per annum. The bond will not be worth buying unless it returns at least the current rate of interest. If the current rate of interest is 10%, then the bond is worth buying only if it costs $100 or less. If the current rate of interest is 15%, then the bond is only worth buying at $66.67 because this is the amount over which $10/year represents a 15% return. In a competitive market, sellers will not be willing to sell at less than the ‘going rate’ so bond prices will be very closely pegged to the price at which they provide a return equal to the currently prevailing rate of interest. (Or: The interest rate is the return on government bonds; the more you have to pay for them, the less return you’re getting.)

 We have established that the speculative demand for money varies based on the expected changes in bond prices. If bond prices are expected to fall, the demand will be high, and vice versa. Since bond prices vary inversely with the interest rate, if the interest rate is expected to rise, the speculative demand for money will be high, and vice versa. It is reasonable to suppose that when the interest rate is quite low, most people will expect it to rise; and when it is quite high, most people will expect it to fall. Therefore, the speculative demand for money varies inversely with the currently prevailing interest rate. If the interest rate is low, then the expectation will be that it will rise, which means that bond prices will fall, which means people would rather hold onto their money so they can buy the cheap bonds later, so the speculative demand for money will be high; and vice versa through the whole process.

 Considering all three types of demand for money, it follows that the overall demand for money balances will vary directly with the level of income and inversely with the rate of interest. Higher (lower) Y means more (less) money held in transactional and precautionary balances. Higher (lower) interest rates mean more (less) incentive to reduce money balances so as to take advantage of investment returns, and also more (less) incentive to purchase government bonds with money otherwise held in speculative balances. For a given Y, the relationship between the demand for money and the rate of interest is called the ‘liquidity preference schedule’ which looks like this:

  

The point on the demand curve that intersects with the (vertical) money supply curve will determine the equilibrium rate of interest. M_T+P represents the amount of money held for transactional and precautionary purposes, which for our purposes is assumed to vary only with Y. Since Y is held constant here, M_T+P is a vertical line: At all rates of interest, the same amount of money is held. The speculative demand for money is a function of the rate of interest, reflected in the sloped portion of the demand curve. However, once a sufficiently low interest rate is reached, the curve becomes horizontal. This reflects the observation that at very low interest rates, households and firms are simply not interested in buying any more bonds. For one thing, the interest rate is so low that everyone is convinced it should rise soon, so nobody will want to invest in current, low-yield bonds. Once this point has been reached, further increases in the money supply will simply find their way to idle balances and further reductions in the interest rate will not occur.

 The Keynesian theory of money, unlike the quntity theory, suggests that changes in the money supply do not lead directly to changes in aggregate demand. Instead, monetary policy affects interest rates, thus indirectly influencing those components of aggregate demand which are sensitive to interest rates. Note that we can conclude from this that the graph above is inadequate to explain the final equilibrium interest rate. The graph above is for a fixed value of Y. But a change in interest rates (at least along the sloped portion of the curve) will result in a change in Y. So the initial equilibrium shown by the graph above cannot be the final value. This will be analyzed in detail later.

 It is also highly noteworthy that Keynesian theory suggests that monetary policy will be ineffective in dealing with a deep recession. When the rate of interest is so low that the liquidity schedule is operating on the horizontal portion of the curve, the government can expand the money supply until it turns purple and no further reductions in interest rate—and therefore no further effect on aggregate demand—will be forthcoming. Keynes suggested that in a deep recession, with substantial spare capacity and pessimistic business expectations, extremely low interest rates would be necessary to stimulate investment, but these rates might be below the minimum to which monetary policy can force the rate. This is the famous ‘Keynesian liquidity trap.’

Money

 The models so far have not included the concept of money. This is unsatisfactory because money clearly plays a part in economics. A complete macroeconomics theory must be capable of explaining the historical behavior of the price level. In addition, money may have an importance beyond the simple measure of prices, because monetary factors may influence “real” values such as output, income and employment.

 Money is anything which is generally acceptable for the settlement of debts. Money does not have to be created by a central authority. In prison, cigarettes can become money simply because they are an acceptable medium of exchange. In many economies the most important source of money is commercial bank deposits. Bank deposits are money because they are generally acceptable for the settlement of debts, rather than through any legal or ‘official’ authority. ‘Legal tender’ is money which has been legally protected such that the refusal to accept it for the settlement of a debt is illegal. Even though bank deposits are not legal tender, many people find a check drawn on a bank deposit account acceptable as a form of money.

 There are three forms of money:

·         Coins

·         Notes

·         Bank deposits

 Money has three functions:

·         A medium of exchange: Without money, goods and services could only be traded through bartering, which is wasteful and difficult, particularly in a highly specialized modern economy. Money is used as a universally acceptable barter substitute. To be useful for this purpose, money must posess the following characteristics:

-          it must be widely acceptable;

-          it must have a high value to weight ratio;

-          it must be divisible to settle debts of differing values;

-          it must be difficult to reproduce, counterfeit or debase in value.

·         A unit of account or measure of value: Money provides a standard by which the value of any good or service can be measured. If a car costs $25,000 and a hamburger costs $2, then a car is worth, and can be exchanged for, 12,500 hamburgers.

·         A store of wealth: A household (or firm) can sell its factor services or goods for money, and then keep the money until it has decided what to do with it. Almost every household and firm holds some amount of money. To act as a satisfactory store of wealth, the value of money must be reasonably stable over time.