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Quantity Money Theory: Equation of Exchange by Irving Fisher

PT=MV + M′V′. Therefore P= (MV + M′V′)/T. Here M is currency and coins

supplied at a point of time. It is both the quantity of Money demanded and
quantity of Money supplied. V is velocity of circulation of money. It is a rate at
which a standard monetary unit changes hands in the course of transactions in a
given year. MV represents the supply of currency and coin over a period. M′
measures the quantity of checkable deposits and other bank deposits at a given
period. Since its supply is governed by the money policy, it will not change every
now and then. V′ is the velocity of bank money. M’V’ represents the supply of
bank money at a given period. V & V’ depend on the consumption habit of the
people that will not change in the short period. Hence, they both will remain
constant in the short period. T represents the volume of transaction that is
governed by a set of factors such as the mode of transaction, the availability of
goods and services, the credit system etc. Hence, T too will remain constant or
independent of M. Because of these reasons, P will vary directly with M i.e. if M
changes, price also changes. Hence, price inflation is directly related to money
supply.

A modified Version: Contemporary economists use a simplified equation of

exchange: MV = PY. Here M stands for money stock of currency in circulation
plus checkable deposits, time deposits and other highly -liquid assets. It is
termed as money stock. V is the income velocity of money. It is equal to the
money value of income and output divided by the money stock. In other words,
velocity is the ratio of GDPN and the money stock. Hence, MV equals GDPN.
P stands for the price level. It is the ratio of GDPN and GDPR. It is GDPN /GDPR. Y
stands for real output. It is GDP R. Hence, PY stands for GDPN. Thus GDPN.=PY. In
other words GDPN. = GDPN is an identity in mathematics that is true by
definition. The percentage form of the above equation is % Δ in M + % Δ in V =
%Δ in P + %Δ in Y.

Quantity theorists assume that velocity is relatively stable; suggesting that the
% change in V is always zero. They also assume that % Δ in Y (GDPR)is
approximately 3%. It will not change in the short period. With these
assumptions, the inflation rate (% Δ in P) will always be 3 % less than the
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growth rate of the money stock (% Δ in M). If the money stock grows at 10 % a
year, the inflation rate will be 7% a year. Therefore, inflation is an exact
mathematical function of the growth rate of money stock, and hence the
equation of exchange can become a theory of inflation.

Criticisms: In reality T, V & V’ will not remain constant. They are fluid
variables and are interdependent. This equation ignores the store of value
functions of money. Often we have seen that governments increase money
supply for various reasons such as paying more DA to the labour force due to
price inflation. Hence, the relationship between M and P are indeterminate. Both
can be cause variables as well as effect variables.

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2. FUNCTIONS OF MONEY. “MONEY IS WHAT MONEY DOES” Explain.

Money has an important characteristic called general acceptability. Anything

that is used in the settlement of debts can be called money. Money is also
defined in terms of its function, money is what money does. Transaction
Approach looks upon money as a medium of exchange. Liquidity Approach
considers money as a temporary store of value, and the Scientific
Construct Approach views money as a measure of value. Money performs
the following static functions.

1. Money as a Medium of Exchange puts an end to all the difficulties of

barter system. There is no need for a double coincidence of wants in the money
economy. A man with horse, if wants to buy cloth, need not seek a cloth seller
who wants his horse. He can sell his horse in the market and then purchase
cloth with the money obtained.

2. Money as Measure of Value: In money economy, values of all

commodities are expressed in terms of money. Money is as if the yardstick of
cloth merchant, measures the value of all varieties goods and services. This
function makes transactions easy, fair, and acceptable.

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 3. Standard of Deferred Payment: In a money economy, the contracts are
made for future payments in terms of money instead of goods and services.
Loans can be raised in terms of money and can also be repaid in terms of
money. In this way, money is the standard of deferred payments. This function
promotes all kinds of economic activities that depend on borrowed money.

4. Money as a Store of Value: Goods cannot be stored for long because of

their perishable nature. For example if cattle when kept for a long time will
become liability to the owner. People receive their incomes in money and keep
their savings in money with banks or invest in money markets. In this way,
money is used to store value of commodities.

The primary functions of money are medium of exchange, and measure of

value. The latter two functions are of secondary importance because they are
derived functions. In addition to the above static functions money also perform
dynamic functions.

Dynamic functions of money: Money has the potential to influence the

economy. It influences the price level, interest rates, resource utilization,
borrowing etc. It aids to specialization, production and trade: The use of money
has helped in removing the difficulties of barter. The market mechanism,
facilitated by money leads to production of commodities, specialization,
expansion and diversion of trade etc. Money is an instrument of making loans:
People save money and deposit it in banks. Financial units advance these
savings to businesspersons and industrialists. Money is thus the instruments by
which savings are converted into investments. In modern economy, money plays
a very important role. Its disappearance would cause disappearance of the
economy itself.

Limitations of money: inflation, deflation, income inequalities, class struggle,

rural migration, all social evils are associated with money.

3. Money laundering is an act of concealing the source, ownership, and

destination of illegally gained money (from drug dealing, tax evasion, and other
types of fraud) through a series of financial transactions involving many

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numbers of criminal acts. It is the process by which the proceeds of crime are
made to appear to have a legitimate origin. The methods of money laundering
can be simple and complex.

Money laundering often occurs in three steps: 1.Cash is introduced into the
financial system by some means and it called placement. 2. Carrying out
complex financial transactions in order to camouflage the illegal source and it
called layering, and 3. Acquiring wealth generated from the transactions of the
illicit funds known as integration. Sometimes some of these steps are skipped,
depending on the circumstances.

Money laundering can be many types. These include bank methods,

smurfing, currency exchanges, and double invoicing. "Smurfing is a
method of placement of the ill gotten wealth in a large number of smaller
deposits of money with banks, so that these transactions defeat suspicion of
money laundering. Sometimes smaller amounts of cash are used to purchase
bearer instruments, such as money orders, and then ultimately deposit those,
again in small amounts. These amounts will be spent later as legitimate money.

Bulk cash smuggling is physically smuggling cash to another jurisdiction,

where it will deposited in a financial institution, such as an offshore bank, that
has greater bank secrecy or less rigorous money laundering enforcement.
Cash-intensive businesses: A business typically involved in receiving cash will
use its accounts to deposit both legitimate and the criminally derived cash,
claiming all of it as legitimate earnings. Trade-based laundering can be
under- or over-valuing invoices in order to disguise the movement of money.
Trusts and shell companies disguise the true owner of money. Depending on
the jurisdiction, they need not disclose its true, beneficial, owner.

Money launderers or criminals park their funds for lower interest rates in a
bank, preferably in a jurisdiction with weak money laundering controls, and then
move the money through the bank without scrutiny. It is known as bank
capture. Often individuals walk in to a casino with huge cash, buy chips or
tokens, play for a while and then cash in their chips for which they will be issued

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checks. The money launderers will then be able to deposits the checks into their
banks, and claim them as gambling winnings.

Real estate may be purchased with illegal proceeds, and then sold out to
create an impression that the proceeds from the sale appear to outsiders to be
legitimate income. Alternatively, the price of the property is manipulated with
the support of the sellers who may not know the source of the funds. Terrorist
activities are elections are often financed by the ill-gotten wealth by money
launders, who in turn get favours to promote their businesses. Often they are
the owners of ghost firms in various countries where their govt follow soft
policies.

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4. CREDIT CREATION BY BANKING SYSTEM

Credit creation is one of the important functions of a commercial bank. It forms

the major component of money supply in the economy. While other financial
institutions transfer money from the lenders to the borrowers, Commercial
banks while doing so create credit or bank money also. That is why Prof.
Sayers says that Banks are not merely suppliers of money, but also the
manufacturers of money.

The process of credit creation occurs when banks accepts deposits and provide
loans and advances. When a customer deposits money with a bank, it is called
primary deposit. The depositor will withdraw this money in due course in
small amounts and not immediately. Hence, banks keeps a certain amount of
deposits as reserves, known as cash reserve ratio (CRR), and provide the
balance amount as loans and advances to the creditworthy borrowers. Thus,
every deposit creates a loan. Commercial banks give loans and advances
against some security to the borrowers. Banks does not give the loan amount
directly. They open an account in the name of their borrowers and deposit the
amount in their accounts. Thus, every loan creates a deposit. The loan amount
is withdrawn by means of checks. The deposits created by banks with the help
of primary deposits are called derivative deposits.

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Customers use these loans to make payments. While paying, they issue checks
against their deposits. The person who receives a check, deposit it in another
bank. For that bank, this will be the primary deposit. A part of the deposit is
kept as a reserve and the balance is used for giving loans and advances. This
process is repeated by other banks. When all the banks involve in this process,
it is called as Multiple Credit Creation.

An example will make multiple credit expansion clear. Suppose, if a person

deposits Rs. 100/- in a bank no.1. Rs.100/- is the primary deposit. Suppose
the minimum cash reserves ratio is 10% to be maintained by commercial banks
as expected by the central bank of the country to meet the demands of its
depositors, the bank can lend out Rs.90/. Primary deposit - Cash reserve =
Derivative deposit. Hence, Rs.100 - Rs.10 = Rs.90. When Rs 90/ is given by
way of loan to a credit worthy borrower B1, the bank will credit the amount to
the borrower’s account which is opened in his name. The borrower B1 can get
the cash and deposit the amount with another bank no2. The second bank can
lend out Rs.81/- out of Rs.90/ to another borrower B3 that will come back to
the bank no3 in the second round as primary deposit. This process will continue
until the primary deposit amount becomes insignificant and if there were no
cash leakages, the credit creation would proceed as shown below:

Primary CRR Rs Derivative Deposit in Rs

deposit(Rs)

100.00 10.00 90.00

90.00 9.00 81.00

81.00 8.10 72.90

A formula can explain the process of credit creation. Total credit created
= Original deposit x the coefficient of credit multiplier, where Credit
multiplier co-efficient = 1/CRR. If CRR is 10%, then the coefficient of
credit multiplier is 1/10% = 1/ 10/100 = 10. Total Credit created = 100 x
10 = 1000/. If CRR rises to 20%, the credit created will be /100 =
1/20

100/20 = 5, so 100 x 5 = Rs.500/-It is clear, that the amount of credit

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created depends on the CRR. Higher the CRR, lesser will be the credit
created and vice versa.

Limitations: 1. Credit creation depends upon the amount of primary

deposits.2. There exists an inverse relation between credit creation and
CRR. During inflation, the CRR will be high to reduce credit and to cool
down the over-heated economy, and during deflation, it will be low to
provide more credit to revive the economy.3. Banking habits of the
people are if well developed, it will lead to expansion of credit.4. In case
of cash transaction, credit expansion will be less, as in the case of
developing countries like India. In India, in recent years however
transaction through bank money is picking up.5. Loans are sanctioned by
banks against some security. If enough securities are available, then
credit creation will be more and vice versa.6. If the entire commercial
banking system follows a uniform policy regarding CRR, this credit
creation would be smooth. 7. If the liquidity preference or cash
preference of the people is high, the credit creation will be less and vice
versa.8. If business conditions are bright then demand for credit will be
more, and hence credit creation will be high.9. Customers should be
willing to borrow from the banks to facilitate credit creation, and 10.
Credit control policy of the Central Bank influences credit creation. For
example during the depression, the RBI encourages the commercial
banks to expand credit by lowering CRR.
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5. Aggregate demand (AD) and aggregate supply (AS) analysis

It sheds light on macroeconomic relationships and the effects of government

policy changes. It is also necessary to understand issues such as inflation,
economic growth and unemployment.

The components of Aggregate Demand: AD = C + I + G + (X-M) Where

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 C: Consumers' expenditure on consumer durables & non-durable goods
such as food etc. Household spending generally accounts for about 70% of
aggregate demand. I: Capital Investment is investment spending by
companies on capital goods such as new plant and equipment and buildings.
It also includes working capital such as stocks of finished goods and work in
progress. G: Government Spending –It includes government spending on
state-provided goods and services such as transportation, health, utilities, etc.
Transfer payments that are not adding any output are excluded. X: Exports of
goods and services ensure an inflow of income to the nation. M: Imports of
goods and services lead to payment to abroad. Net exports (X-M) reflect
the net effect of international trade on the level of aggregate demand. When
net exports are positive, there is a trade surplus adding to AD. When net
exports are negative, there is a trade deficit reducing AD.

AD curve cultivates a negative relationship between inflation and National

income (Real GDP). Under falling general prices (falling inflation rate), national
income increases and vice versa. Here we assume exogenous variables such as
monetary, fiscal, exchange rate policies of the govt to remain constant.

   Causes for downward slope: a) As the price level rises, the real value of
incomes of the people falls and hence consumers are constrained to buy less
domestic goods and services. b) As the price level rises, foreign goods and
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services become cheaper in price terms, causing a fall in exports and a rise in
imports. This will lead to a cut in trade (X-M) resulting in a contraction in
aggregate demand, and c) when the price level increases, this causes an
increase in the demand for money by the people to spend on goods and
services. Their savings hence will go down. This causes a rise in interest rates
with a deflationary effect on the entire economy.

Many unexpected events in a nation can cause changes in the level of demand,
output and employment in the economy. These unplanned events are called
“shocks”. They can cause fluctuations in the level of economic activity. These
shocks happen from demand side as well as supply side. Shocks are possible
due to the changes in exogenous variables.

Demand-side shocks originate from many sources. 1) A construction boom

increases the supply of new houses and new commercial and industrial
buildings. This shifts AD curve shifts upwards. 2) A rise or fall in the
exchange rate can affect net export, which in turn can bring about compelling
changes on output, employment, incomes and profits of businesses linked to
export industries. 3) A consumer boom in one of the major trading
partners can increase the demand for exports of goods and services. Finally 4)
a slump in share prices and 5) an unexpected rise and fall in interest
rates can also cause demand shocks. These can cause shifts in AD curve.

Shifts in the AD curve: A change in factors affecting any one or more

components of aggregate demand(C, I, G, or X), results in a shift in the AD
curve. The diagram below shows an inward shift of AD from AD1 to AD3 and an
outward shift of AD from AD1 to AD2. The rise in AD is also possible by a fall in
interest rates or an increase in consumers’ wealth because of rising house
prices.

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  Factors causing a shift in AD

1. When expected increases in consumer incomes, wealth or company profits

encourage households and firms to spend more, it boost AD upwards. Similarly,
when higher expected inflation encourages spending now before price increases
come into effect AD goes up. 2. When confidence over the economy turns lower,
people save more for future and some companies postpone capital investment
projects because of worries over a lack of demand and a fall in the expected rate
of profit on investments. These will push AD curve downwards. 3. An
expansionary monetary policy will move AD curve upwards. When interest rates
fall, this lowers the cost of borrowing and the incentive for saving. This can
encourage consumption. Lower interest rates encourage firms to borrow more
and invest. There will always be time lags between changes in interest rates and
the changes on the components of aggregate demand.4. Changes in fiscal policy
can also move AD up and down depending on the situation. When the
Government increase its expenditure on socio-economic infrastructure etc, it
increases AD. Lower rates of income tax raise disposable income and should
boost consumption. Hence, AD moves upward.5. International factors such as
the exchange rate and foreign income flows can also change the positions of AD.
6. Changes in household wealth can also causes changed in AD. A rise in house
prices or the value of shares increases consumers’ wealth and allow an increase
in borrowing to finance consumption increasing AD. In contrast, a fall in the

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value of share prices will lead to a decline in household financial wealth and a fall
in consumer demand.

Aggregate Supply

Aggregate supply (AS) measures the volume of goods and services produced
within the economy at a given price level. It represents the ability of an
economy to produce goods and services either in the short-term or in the long-
term. It tells the quantity of real GDP that will be supplied at various price levels.
In the long run the aggregate-supply curve is assumed to be vertical, while in
the short run the curve is upward sloping as shown below. Short run
aggregate supply (SRAS) shows how total planned output changes when
output prices in the economy changes while the input prices such as wage rates
etc and their productivities are held constant. Long run aggregate supply
(LRAS) shows total planned output when input and output prices change. LRAS
is a measure of a country’s potential output.

SRAS Curve: It measures inflation in the vertical axis and real GDP in the
horizontal axis. There is a positive relationship between the two variables.

A change in the price level results in a movement along the SRAS curve. Its
slope depends on the degree of spare capacity or under-utilised capacity within
the economy. Due to various reasons when actual GDP < potential GDP, firms
have a large amount of spare capacity or underutilized capacity and they can
expand their output without paying their workers overtime etc. Under such

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situation SRAS curve will elastic. We call it Negative output gap. When actual
GDP> potential GDP, national output expands and the economy heads towards
full capacity. Under such a situation, supply bottlenecks and shortages may
appear in some sectors and industries. Workers in addition to their wages may
get overtime payment and bonuses to work longer hours and increase GDP.
Hence, SRAS now becomes more inelastic. We call it Positive output gap. As
national output expands, older less productive machinery may be used and less
efficient workers hired. These result in a rise in the unit costs of production and
thus the SRAS slopes upwards due to diminishing returns. Eventually the
economy cannot increase the volume of output further through any means and
at this point SRAS is perfectly inelastic. It implies that the economy has reached
full capacity. Now the LRAS curve becomes relevant.

Factors causing shifts in short run aggregate supply (SRAS): A rise in

unit labour costs or a fall in the level of worker productivity will finally lead to
cost posh inflation. This leads to an inward shift of SRAS curve resulting in
cutbacks in national output. Such shifts are also possible when the prices of raw
material, imported inputs, and other components go up. A fall (depreciation) in
the exchange rate increases the costs of importing raw materials and component
supplies from overseas. An increase in taxes designed to meet the government’s
environmental objectives will also cause higher costs and an inward shift in the

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short run aggregate supply curve. A rise in VAT on raw materials will have the
same effect.

The short run aggregate supply curve is upward sloping as shown below
because higher prices of goods and services make output more profitable and
enable businesses to expand their production by hiring less productive labour
and other resources.

The most important single cause of a shift in the short run aggregate supply
curve is a change in wage rates. Higher wage rates without any compensating
increase in labour productivity by raising the production costs, lead businesses
to produce less output. Hence, the aggregate supply curve will shift to the left
from SRAS1 to SRAS2. Conversely, a fall in raw material prices or component
costs will reduce production costs, encouraging firms to produce more and
hence, the aggregate supply curve moves to the right from SRAS1 shifts to
SRAS3.

Long run aggregate supply (LRAS) shows the ability of an economy to

produce goods and services based on the state of production technology and
the availability and quality of factor inputs. In the long run aggregate

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supply is independent of the price level. As a result, LRAS curve is vertical. It
implies that an economy cannot exceed its production beyond a certain limit
given the resources. In other words, it shows that the economy is in full-
employment level of national income..

Many factors Cause shifts in LRAS curve: They include improvements in

productivity and efficiency or a change in production technologies or the finding
of new resources such as oil and mineral deposits, or increase in the stock of
capital and labour resources, or increase the occupational and geographical
mobility of labour or increase in business efficiency, or invention and
innovations or all the above factors can cause the LRAS curve to shift out as
shown in the diagram below. The result is that a great volume of national output
can be produced at any given price level. 

Aggregate supply shocks

Aggregate supply shocks occur, when there is a sudden rise in oil prices and/ or
other essential inputs. This also possible when there is invention and diffusion of
a new production technologies. All the above may also operate at a time.

Supply-side shocks normally cause a shift in the short run aggregate supply
curve. But, there are also occasions when significant changes in production

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technologies or factor productivities can a shift the long run aggregate supply
curve.

 Macroeconomic equilibrium for an economy in the short run is established

when aggregate demand intersects with short-run aggregate supply. This is
shown in the diagram below

At the price level Pe, the aggregate demand for goods and services is equal to
the aggregate supply of output.  The output and the general price level in the
economy will tend to adjust towards this equilibrium position. If the price level is
too high, there will be an excess supply of output. If the price level is below
equilibrium, there will be excess demand in the short run. In both situations
there should be a process taking the economy towards the equilibrium level of
output. For example, in the face of growing unsold stocks of output, producers
either cut prices to stimulate an increase in demand or to reduce output to
reduce the excess stocks. Either way - there is a tendency for output to move
closer to the current level of demand. When an economy reaches full-
employment of factor resources, the aggregate supply curve in the short run
becomes increasingly inelastic.

In the diagram below, we see aggregate demand rising but the economy finds it
difficult to expand production. There is a small increase in real national output;

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hence, the economy will suffer from demand-pull inflation. Shortages of
resources in due course will lead to a general rise in costs and prices.

Increased efficiency and productivity together with lower input costs cause
the short run aggregate supply curve to shift outwards as shown below. When
AS shifts outwards and a new macroeconomic equilibrium is established with
price level has fallen from p1 to p2 and real national output increases to Y2.

Aggregate supply would shift inwards if there is a rise in the unit costs of
production in the economy. External economic shocks such as a rise in global
commodity prices might also cause the aggregate supply curve to shift inwards.
In the diagram below, we see the effects on an inward shift in aggregate
demand in the economy. A decline in business confidence or a fall exports
following a global downturn or a cut in government spending or a rise in interest
rates can lead to cutbacks in consumer spending. This causes downward
pressure on the general price level.

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If aggregate demand shifts outwards perhaps due to increased business
confidence, an economic upturn in another country, or higher levels of
government spending, we could expect both a rise in the price level and higher
national output.

National Income when Aggregate Supply is perfectly elastic: When short

run aggregate supply is perfectly elastic, any change in aggregate demand will
bring about changes in output without changing the general price level. For
example, as shown below when AD shifts out from AD1 to AD2 the economy is
able to meet this increased demand by expanding output to Y2. Conversely
when there is a fall in total demand for goods and services from AD1 to AD3 we
see a fall in real output.

Long Run Economic Growth

For an economy to experience sustained economic growth over the longer run, it
must shift out the LRAS curve by either increasing the supply of factors of
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production available or increasing the productivity of them or by achieving an
improvement in the state of technology.

If LRAS shifts out the economy can operate at a higher level of aggregate
demand and can achieve an increase in real national output without running into
problems with inflation.

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