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1. Learning Outcomes

After studying this module, you shall be able to

Know the different concepts related to the value of money

Derive how money determines prices in the economy
Identify how money becomes neutral in long run
Evaluate short run and long run perspectives on money
Analyze interplay of output, employment, wages, money and prices

2. Introduction

The macro economic theory is determined with the determination of output, employment,
money, price and inflation. The previous modules have explained the first two
components in detail. In this module we talk about the money and determination of
prices. Money has always played a very important role in any economy. Its most crucial
role is in the determination of price level. The relationship between money and prices can
be viewed from the perspective of different school of thoughts.
The quantity theory of money (QTM) refers to the proposition that there is one on one
relationship between the quantity of money supplied in the economy and the price level.
The QTM is an old theory, dating back to Europe where it was developed as a response to
the influx of precious metals from the New World, and in this sense it is one of the oldest
theories in economics. Nevertheless, according to the records of the late
does one start to find theoretical statements that justify the connection between Ms and P.

For classical economists, who basically functioned around , used this conjecture
to explain money and prices. QTM became a constituent component of their theory of
value and distribution. But they defined one sided causal relationship. According to
classists, prices affected the quantity of money and not the other way around. So for
classists money is endogenously determined-that is, determined within the economic
framework.

For neo classists, the QTM was explained by Irving Fisher (1867-1947).

for total volume of transactions and not only of final goods. Another important

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development was made by Knut Wicksell, who stressed upon the endogeneity of the
money supply and its effect on price level.

The Keynesian economics in the 1930s gave very little attention to the QTM and it was
used only for the determination of nominal magnitudes of real variables. According to the
Keynsian analysis there is only indirect relationship between of money supply in the
economy and that is through interest rates.

The monetarists, who laid a characteristically different view, specially, Milton Friedman
(1912 2006) who gave much importance to money and said it is responsible for almost
every economic phenomenon. In fact, Friedman illustrated that the major economic
episodes in U.S. economic history from the Great Depression of the 1930s to the
inflation of 1970s could be explained through variations in money supply. He stressed
that tight monetary policy was ineffective instrument in bringing about the economic
stability in that time. He stressed that in Great depression of 1930s was primarily caused
by the tight monetary policy adopted at that time.

Further on we shall study how each school of thought explained their conjecture on role
of money in determination of prices and they all are in harmony with the fact that money
is neutral in long run.

3. Quantity theory of money

The quantity theory of money seeks to explain the value of money in terms of its
quantity. Stated in simplest form the quantity of money says that prices varies directly
with the quantity of money. According to QTM, double the supply of money and other
things being constant, the prices will also double. And thus value of money would halved
and vice versa. TO explain QTM, we first need to define some important term used in
this concept.

(a) the volume of trade

(b) the quantity of money
(c) velocity of circulation of money

The first component is the volume of trade. By volume of trade is meant the total
transaction done in a given period. This is equal to the real value of goods and service
produced in an economy. Greater the supply of goods and services in an economy, larger
is the volume of trade. The classist believed that an economy at each time is at full

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employment, that is output is at its potential. This simply meant that given the total
factors of production in a given time period, the real value of output produced is at its full
employment.
The second component in the determination of the level of prices in the economy is the
quantity of money. It consists of notes and currency in the economy plus the credit or
deposits created by the banks.
The third component is the velocity of circulation. This simply means number of times a
money bill is circulated in the economy or the number of times a money bill changes
hands. This is required because money is used to buy goods and services, whose value is
determined by the value added by each factor. The supply of money is never equal to the
total output. The total output is equal to the stipulated money supply and number of times
money is circulated (it changes hand to buy the produces goods and services).

The classists defined that level of prices in the economy is affected by the above
mentioned components. They defined the relationship between prices and money using

Where, M is the money supply

V is the velocity of circulation
P is the level of prices in the economy
Y is the real output in a given period

Thus the above mentioned is the famous equation of exchange. It explains that the
nominal value of the output produced at a given period in times (that is, PY) is equal to
the quantity of money and velocity of circulation. They assumed velocity to be a constant
(V) and that since output is always at its full employment, so it is constant as well (Y),
then according to this equation, prices (P) is directly related to the quantity of money in
the economy.

So, if money supply is increased by say 10%, prices will also increase by 10% and vice
versa. The classists defined inflation to be always and everywhere a monetary
phenomenon. This is so because, the output is at its full employment and hence cannot be
increased. The velocity is also assumed to the constant in short run because it depends on
the development of banking and credit system and speed with which cheques are cleared

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and loans are granted and repaid and these practices do not change in short run. Thus, the
money and prices in the economy has direct relationship. This equation is an accounting
identity and hence true by definition. This is because MV which represents money spent
in transactions must be equal to PT which represents money received from transactions.

The quantity theory of money (QTM) asserts that aggregate prices (P) and total money
supply (M) are related according to the equation P = VM/Y, where Y is real output and V
is velocity of money. With lower-case letters denoting percentage changes (growth rates),
the QTM can be expressed as p = v + m y, with p as the rate of inflation and y, v, and m
as growth rates of output, velocity, and money stock, respectively. A central implication
of the QTM is that a given change in the rate of money growth induces an equal change
in the inflation rate, prompting Milton Friedman to claim that
everywhere a monetary phenomenon

A crucial assumption behind this claim is that the velocity of money or its growth rate is
constant and money growth has no effect on real GDP growth at least at a sufficiently
long time horizon.

4. Classical dichotomy

The classical dichotomy refers to the idea that in an economy there coexists two kinds of
variables- real and nominal. Real variables, like output and employment, are independent
of monetary variables. In this view, the primary function of money is to act as a medium
of exchange for the transactions to take place in a economy. This conception of money
-type economy as a system of barter
between rational utility-maximizing individuals.

Hence is just a medium of exchange. T

than to overcome transaction costs concerning the inconveniences of barter, which result
from the absence of a double coincidence of wants, a core disadvantage of barter system
of trade.

The classical dichotomy is an important interpretation of the quantity theory of money,

which is given by the formula MV = PY, where M stands for the money stock, V is the
velocity of money circulation, P is the price level, and Y is the level of income. the
nominal output (PY) should be equal to the nominal money supply. Exogenous changes
in the money supply (M) ultimately condition the price level for a given level of

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economic activity. If an economic system is at full employment, the only effect of

increases in the money supply is a proportionate increase in the domestic price level,
which gives rise to a depreciation of
causality runs therefore from an exogenous money supply to the price level.

This is interrelated with the natural interest rate theory, according to which when output
is at full employment there is a market determined interest rate level at which the market
clears.

Exogenous changes in the supply of money are what shift market rates of interest. This is
the process by which discrepancies between market rates and the natural rate of interest
are generated. A market rate of interest below the natural interest rate occurs when
investment exceeds savings. Firms will demand more credit for investing. The result is an
excess of investment over savings. If the economy is at the full-employment position,
defined by the natural rate of interest, a cumulative process of inflation unfolds. The rise
in the price of consumption goods leads to a decrease in consumption; involuntary
savings rise until the excess of investment over savings is eventually eliminated. If
market rates of interest are above the natural rate of interest, by contrast, savings exceed
investment and a cumulative process of deflation ensues.

In conclusion, the classical dichotomy implies that real variables and monetary variables
are independent of each other. From a heterodox perspective, by contrast, both kinds of
variables are explained by the relationship established between the central bank, bank

profitable, reversing thereby the causality of the quantity-theory-of-money formula.

5. Long run neutrality of money

The quantity theory of money predicts that in the long run, the quantity of money will not
affect anything real. This result is called the long-run neutrality of money. Figure 1
illustrates this proposition. Suppose the people want to hold 5 percent of their income in
money holding, that the long-run real level of output is 4,000, and that the money supply
is $400.

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Figure-1

Aggregate demand will be $8,000, and the price level will be $2. If the money supply
increases to $800, aggregate demand will be $16,000. At the full employment output of
4,000. The price level will double to $4. Nothing real has changed; only all prices and all
incomes have doubled in their dollar amounts.

Figure-2

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Points to Note about Figure 2

1. Total spending is $8,000 at all points on the AD = $8,000 curve. Along this curve,
the money supply is $400 and velocity is 20 (k = 0.05).
2. Total spending is $16,000 at all points on the AD = $16,000 curve, along this
curve, the money supply is $800 and velocity is still 20.
3. Velocity stays unchanged in the quantity theory of money.
4. Doubling the money supply from $400 to $800 doubles the price level from $2 to
$4.
5. The price level can be found by dividing aggregate demand by Q.

One way to understand the quantity theory is to realize that while the Fed can
change the nominal money supply, in the long run, it has no effect on the real money
supply. For example, in Figure 2, at full employment, whatever the nominal money
supply is, the real money supply will always be 5 percent of real output (MS/P = kQ) or
200. The 200 stands for the output that money holding can buy (200 baskets of goods).
Another way to understand the quantity theory is that, in the long run, increase aggregate
demand (total dollar spending) can be increased in only two ways. One is to increase the
money supply. The other is to decrease k, the fraction of income people want to hold in
money balances (note that decreasing k is the same thing as increasing velocity). For
example, the introduction of credit cards most likely decreased the need for money
holdings, resulting in a lower k.
1. According to the quantity theory of money, people want to hold a certain fraction
(k) of their income in money (MD=k$GDP). Each dollar will be spend on overage
V times a year, where V = 1/k. V is called velocity.
2. The quantity equation of money is:
MS x V = P x Q
Or
MS = k x P x Q
3. The nominal money supply is fixed by the Fed. The real money supply is
determined by the public in the long run (MS/P=kQ).
4. Aggregate demand ($GDP) = MS x V = MS/k.
5. In the long run, changes in the money supply affect only prices, not output.

6. How to predict inflation

To predict inflation with the quantity theory, economists put the quantity theory
into its percent form:
% P= % MS - % Q + % V
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or
% P= % MS - % Q + % k
% stands for the percent change. The percent change in prices (% P) is the rate
of inflation. % MS is the growth rate in real GDP. For example, if the money supply
grows at 7 percent, output grows at 3 percent, and velocity (V) grows at 1 percent, the
inflation rate will be 5 percent. For many years, the velocity of M2 grew at a steady 1
percent rate, making the equation remarkably accurate when applied to long periods of
time. In recent years, velocity has become less stable, making the equation less useful.
We get the following predictions from this equation (each prediction holding the
other variables unchanged):
1. The rate of inflation will increase when the money supply grows at a faster rate. If
growth rate in the money supply goes up by 5 percent, inflation will increase 5
percent.
2. The rate of inflation will go down when output grows faster. If the GDP growth
rate jumps from 1 percent a year to 3 percent a year, the inflation rate will be 2
percent lower.
3. High rates of inflation are always caused by the money supply increasing Changes
in Q and V are just too small to explain inflation rates exceeding 6 percent.

At the peak of an expansion, commentators often say that rising output will fuel
more inflation. Instead, as we can see, rising output douses inflation. The commentators
are confusing cause and effect. A rising aggregate demand increase total output in the
short run, but in the long run, it leads to more inflation. The rise in output does not cause
the higher prices; the rise in aggregate demand cause output and then prices to rise. Had
output expanded more, inflation would have been less!

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7. Summary

It can be said that the quantity theory is yet again existed, yet contradicted. Its most
recent demise had two causes, each a new manifestation of an old weakness. First, money
growth targeting, a practical, but diluted, application of Friedman's policy proposals, did
not work well, and this happened in some measure because its adoption provoked
institutional adaptations that then undermined it. This should not have come as a surprise
to anyone aware of what the consequences of the 1844 Bank Charter had been for the
quantity theory's reputation in an earlier era, but evidently it did. Second, the New
classical money-supply surprise model of the cycle - a still quantity-theory-based
successor to Friedman and Schwartz's monetarist approach - reformulated the
expectations-augmented Phillips curve as an aggregate supply curve and hence reverted
to Fisher's hypothesis that price level fluctuations led those in real variables in the
transmission mechanism of monetary impulses. It thus set itself up for gross empirical
failure when faced with the basic facts of the timing of the real and nominal responses to
monetary impulses that Friedman and Schwartz, among others, had so thoroughly
documented in the meanwhile.

Given these two failures, it was not surprising that most macroeconomists would soon
discard the quantity theory and succumb to real business cycle theory and New
Keynesian economics, neither of which leaves any significant space for money to play a
role in the economy, The goal of stable money, in the guise of inflation targets,
nevertheless survived the quantity theory's disappearance for a while, only to be
threatened by yet another repetition of history, namely the apparent failure before 2008,
as before 1929, of the price level to give a clear warning about the approach of a major
economic crisis. Whether all this means that the quantity theory is finally dead, or only
that it has gone into hiding prior to beginning yet another of its nine times ninety lives,
remains to be seen. Historians of economics will be inclined to bet on the latter
possibility, and therefore continue to take an interest in this doctrine's earlier
incarnations, not least the one which Irving Fisher did so much to shape.

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