ANNEXURE – II

THEORY OF MONEY (DEMAND FOR MONEY AND SUPPLY

OF MONEY)
Submitted to
CHITKARA BUSINESS SCHOOL (B.Com Department)
Internal Evaluation for Economics Module

Submitted by: Supervised by:

Mrs. Priya
SIMRANJEET KAUR- 2020991578
BHAVAY AHUJA -2020991571
Jindal(Faculty)
MANDEEP SINGH-2020991575
SONIA SHARMA-2020991627
TARANPREET KAUR-2020991605
 ACKNOWLEDGEMENT
We are very grateful because we our managed to
complete our Theory of Money assignment within the
given time by our professor Mrs. Priya Jindal.
This assignment couldn’t be completed without the
efforts and cooperation by our group members.
We also thank our lecturer of Economics , Mrs. Priya
Jindal for the guidance and encouragement for
finishing this assignment and also for teaching us this
course.
And at last we would like to thanks our family and
friends for their constant source of inspiration.

Theories of Money Supply: The Relationship of Money Supply

The effects of money in an economy are crucial points. The literature review
that is presented in this paper gives the chronology of the theories and
approaches in different periods of time from several economists. The studies
have begun under the Classical frameworks, where it is said that money has no
relationship with inflation. Then Fischer came with its Quantity Theory, where
velocity is a constant element. To continue with the Cambridge Approach
(Marshall and Pigou) and The Keynes theory, as a latest Cambridge Approach,
gave a different view from the previous. They stated that interest rate
influenced the money supply and Velocity is not constant. The research
continuous with the post Keynesians (Moore and Kaldor, Ricardo, Marx and
Eltis), where the important theory was The Labor Theory of value, where the
economy works under a full employment resources. Finally, the paper
concluded with the Modern Quantity of Money and New-Classical economists .
The paper continuous with the effects of inflation in relation to
unemployment, wages, taxes and exchange rates. From the studies is found
out that changes in Inflation creates changes in the above factors.
Furthermore, the paper is followed by the empirical study, taking the
Albanian’s data from the year 1994-2015 for Money supply, GDP growth rate,
Interest rate and Inflation. From the survey, the paper found that there is a
strong relation between Inflation and the other variables.

According to the money theories, money supply has a positive sign related to
inflation, while in contradiction to the theory; the empirical results showed
that money in Albania has a negative relationship with inflation, because of the
lack of other financial markets. Albania has only the banking system and
money is strongly linked to the interest rate and the macro development of the
country. Without other financial and capital markets, the supplier of the
money is done only by the banking system. Since the beginning of the financial
crisis in 2008, Albania has been attached to crisis because of the strong
connection of trade with European countries, especially Greece and Italy.
During these difficult years, Albania has been accompanied by an increase of
unemployment, reduction of production, consumption, trade and increase of
budget deficit and public debt. The business and consumer transactions are
shrunken only to the basic ones. Consumers do not spent more than the
necessary products and businesses do not invest in new projects. All the
supplied money is fully absorbed by the market and there is no free circulation
of money, in order to cause inflation. Inflation is reduced year by year, by
reaching the lowest level during these 25 years of transition. Albania is in a
critical point of development and recession has caused a worse financial and
economical situation. Consumption, trade and investments have been
significantly reduced, by not giving a hint to the economic growth. The
conclusion summarizes all the theoretical and empirical part of the paper with
suggestions for better policies in the future.
NEED OF MONEY:

According to the quantity theory of money, if the amount of money in an

economy doubles, price levels will also double. This means that the consumer
will pay twice as much for the same amount of goods and services. This
increase in price levels will eventually result in a rising inflation level; inflation
is a measure of the rate of rising prices of goods and services in an economy.
The same forces that influence the supply and demand of any commodity also
influence the supply and demand of money: an increase in the supply of
money decreases the marginal value of money–in other words, when the
money supply increases, the buying capacity of one unit of currency decreases.
As a way of adjusting for this decrease in money's marginal value, the prices of
goods and services rises; this results in a higher inflation level.

One implication of these assumptions is that the value of money is determined

by the amount of money available in an economy. An increase in the money
supply results in a decrease in the value of money because an increase in the
money supply also causes the rate of inflation to increase. As inflation
rises, purchasing power decreases. Purchasing power is the value of a currency
expressed in terms of the amount of goods or services that one unit of
currency can buy. When the purchasing power of a unit of currency decreases,
it requires more units of currency to buy the same quantity of goods or
services.

Throughout the 1970s and 1980s, the quantity theory of money became more
relevant as a result of the rise of monetarism. In monetary economics, the
chief method of achieving economic stability is through controlling the supply
of money. According to monetarism and monetary theory, changes in the
money supply are the main forces underpinning all economic activity, so
governments should implement policies that influence the money supply as a
way of fostering economic growth. Because of its emphasis on the quantity of
money determining the value of money, the quantity theory of money is
central to the concept of monetarism.

Objectives Of theory of money:

Demand for Money:

The old idea about the demand for money was that money was
demanded for completing the business transactions. In other words, the
demand for money depended on the volume of trade or transactions. As
such the demand for money increased during boom period or when the
trade was brisk and it decreased during depression or slackening of
trade.

Broadly speaking, there are three main motives on

account of which money is wanted by the people by the
people, viz:
(i) Transactions Motive:
This motive can be looked at:
(a) From the point of consumers who want income to meet the household
expenditure which may be termed the income motive, and

(b) From the point of view of the businessmen, who require money and want to
hold it in order to carry on their business, i.e., the business motive.

(ii) Precautionary Motive:
Precautionary motive for holding money refers to the desire of the people to
hold cash balances for unforeseen contingencies People hold a certain amount
of money to provide tor the risk of unemployment, sickness, accidents and
other more uncertain perils. The amount of money held under this motive will
depend on the nature of the individual and on the conditions in which he lives.

(iii) Speculative Motive:

The speculative motive relates to the desire to hold one’s resources in liquid
form in order to take advantage of market movements regarding the future
changes in the rate of interest (or bond-prices). The notion of holding money
for speculative motive is a new typically keynesian idea. Money held under the
speculative motive serves as a store of value as money held under the
precautionary motive does. But it is a store of money meant for a different
purpose.

Supply of Money:
We have described the demand for money as the demand for the stock (not
flow) of money to be held. The flow is over a period of time and not at a given
moment. In the case of commodity, it is a flow. Goods are being continually
produced and disposed of. This is the essential difference between the demand
for money and the demand for a commodity.

Similarly, the supply of money conforms to the ‘stock’ concept and not the
‘flow’ concept. Just as the demand for money is the demand for money to
hold, similarly, the supply of money means the supply of money to hold.
Money must always be held by someone, otherwise it cannot exist. Hence, the
supply of money means the sum total of all the forms of money which are held
by a community at any given moment.

The stock of money, which constitutes the supply of it, consists of (a) metallic
money or coins, (b) currency notes issued by the currency authority of the
country whether the Central bank or the government, and (chequable bank
deposits. In old times, the coins formed the bulk of money supply of the
country. Later, the currency notes eclipsed the metallic currency and now the
bank deposits in current account withdraw-able by cheques have
overwhelmed all other forms of money.

The total amount of bank deposits in the country is determined by the

monetary policy of the central bank of the country. When the central bank
wants to give a boost to the economy of the country, it follows a cheap money
policy, lowers the bank rate, which is followed by lower rates of interest
charged by the commercial banks, thus helping credit creation by the banks.

There are times, however, when in the interest of economic stability, the
central bank follows a policy of credit squeeze by raising the bank rate and
purchasing securities through open market operations and adopting other
credit control measures.
Conclusion:
Thus, the supply of money in a country, by and large, depends on the credit
control policies pursued by the banking system of the company. 

DETAILS OF ACTUAL STUDY

Other has described the price of money as the cost of Indian forex against
foreign currencies.
On the different hand, few economists have related the time period price of
money with the internal purchasing power of a nation. However, logically,
price of money is associated with its buying power, which refers to the volume
of goods and services that can be bought with a unit of money. The values of
money and rate levels in a U.S.are inversely proportional to each other. For
example, when the charge stage in a united states of america is high, the fee of
money is low and vice-versa

a.) Quantity Velocity Approach/Cash Transaction Approach/Freidman’s  

Till now, the economists believed that the price level show changes because of
the changes in quantity (demand and supply) of money. However, in the
present scenario, most of the economists have believed that quantity theory of
money is not applicable in practical situations. Quantity of money comprises
cash (M) and its velocity (V).
The velocity of circulation of cash depends on various factors, such as
frequency of transactions, trade volume, type of business conditions, price
levels, and borrowing and lending policies. According to the quantity theory of
money, the changes in price level of a country occur due to changes in the
quantity of money in circulation, while keeping other factors at constant. In
other words, an increase or decrease in the price level would occur due to
increase or decrease in the quantity of money.
Therefore, it can be concluded that price level and quantity of money are
directly proportional to each other. However, in extreme conditions, an
increase in the quantity of money would lead to a proportional decrease in the
value of money, while keeping other factors at constant and vice versa.
b. Cash Balances Approach/Cambridge Equation:
Cash balances method is the modification of quantity velocity strategy and is
broadly ordinary in Europe. This approach is based on country wide earnings
approach and considers the thought of liquidity. According to cash balances
approach, the cost of money relies upon on the demand and supply of cash
balances for a given duration of time. The demand for cash is not only based
on the volume of items and offerings that would be exchanged, but also on the
time duration at which the transaction takes place.
For example, an individual would not buy food grains for the complete year at
once, however he/she would buy on month-to-month basis. Therefore, he/she
is required to keep enough money with him/her to buy meals grains and other
products from month after month.
Thus, if in an economic system humans are ordinary for keeping money for
overcoming their expenditure for a longer duration of time, then the demand
for money would be more. In such a case, only a small phase of income is held
via individuals and relaxation of the amount is invested.
This is because keeping a massive amount of cash as idle money would be a
loss or danger for the individual On the different hand, money balances held by
using individuals ought to additionally now not be very low, so that
contingencies cannot be overcome.
c. Income-Expenditure Approach:
The income-expenditure approach is given by Keynes. It is also termed as the
modern theory of money. Keynes was agreed with the concept that changes in
quantity of money produces changes in the price levels, as given in the
quantity theory of money.
However, he did not agree with the view that determining relationship
between quantity of money and price level is as easy as demonstrated by
quantity theory.
According to the modern theory of money, changes in price level are brought
by the changes in national income rather than quantity of money. The main
reason for the change in the price level is the changes that occur in the
aggregate income or expenditure. Therefore, change in quantity of money can
only bring changes in the price level when it can change the aggregate
expenditure with respect to the supply of output.
If there is no rise in the expenditure, then the demand for goods would not rise
and consequently, the price level would not increase. In case, the expenditure
rises but the supply of output is fairly elastic, then also the price level would
not rise.

Keynes does not agree with the older quantity theorists that there is a direct
and proportional relationship between quantity of money and prices.
According to him, the effect of a change in the quantity of money on prices is
indirect and non-proportional.
Keynes complains “that economics has been divided into two compartments
with no doors or windows between the theory of value and the theory of
money and prices.” This dichotomy between the relative price level (as
determined by demand and supply of goods) and the absolute price level (as
determined by demand and supply of money) arises from the failure of the
classical monetary economists to integrate value theory with monetary theory.
Consequently, changes in the money supply affect only the absolute price level
but exercise no influence on the relative price level.
Further, Keynes criticises the classical theory of static equilibrium in which
money is regarded as neutral and does not influence the economy’s real
equilibrium relating to relative prices. According to him, the problems of the
real world are related to the theory of shifting equilibrium whereas money
enters as a “link between the present and future”.

Keynes’s Reformulated Quantity Theory of Money:

The Keynesian reformulated quantity theory of money is based on the
following
1. All factors of production are in perfectly elastic supply so long as there is any
unemployment.
2. All unemployed factors are homogeneous, perfectly divisible and
interchangeable.
3. There are constant returns to scale so that prices do not rise or fall as output
increases.
4. Effective demand and quantity of money change in the same proportion so
long as there are any unemployed resources.
Given these assumptions, the Keynesian chain of causation between changes
in the quantity of money and in prices is an indirect one through the rate of
interest. So when the quantity of money is increased, its first impact is on the
rate of interest which tends to fall. Given the marginal efficiency of capita], a
fall in the rate of interest will increase the volume of investment.
The increased investment will raise effective demand through the multiplier
effect thereby increasing income, output and employment. Since the supply
curve of factors of production is perfectly elastic in a situation of
unemployment, wage and non-wage factors are available at constant rate of
remuneration. There being constant returns to scale, prices do not rise with
the increase in output so long as there is any unemployment.
Thus so long as there is unemployment, output will change in the same
proportion as the quantity of money, and there will be no change in prices; and
when there is full employment, prices will change in the same proportion as
the quantity of money. Therefore, the reformulated quantity theory of money
stresses the point that with increase in the quantity of money prices rise only
when the level of full employment is reached, and not before this.
 INTERPRETATION OF THEORY OF MONEY

Definition:
Quantity theory of money states that money supply and price level in an
economy are in direct proportion to one another. When there is a change in
the supply of money, there is a proportional change in the price level and vice-
versa.
Description: 
The theory is accepted by most economists per se. However, Keynesian
economists and economists from the Monetarist School of Economics have
criticized the theory.

According to them, the theory fails in the short run when the prices are sticky.
Moreover, it has been proved that velocity of money doesn't remain constant
over time. Despite all this, the theory is very well respected and is heavily used
to control inflation in the market.
The Fisher equation is calculated as:

M×V=P×T

Where:

M=money supply

V=velocity of money

P=average price level

T=volume of transactions in the economy

Generally speaking, the quantity theory of money assumes that increases in

the quantity of money tend to create inflation, and vice versa. For example, if
the Federal Reserve or European Central Bank (ECB) doubled the supply of
money in the economy, the long-run prices in the economy would tend to
increase dramatically. This is because more money circulating in an economy
would equal more demand and spending by consumers, driving prices north.

Economists disagree about how quickly and how proportionately prices adjust

after a change in the quantity of money. The classical treatment in most
economic textbooks is based on the Fisher Equation, but competing theories
exist.

ANALYSIS OF THEORY OF MONEY

According to the modern theory of money, changes in price level are brought
by the changes in national income rather than quantity of money. The main
reason for the change in the price level is the changes that occur in the
aggregate income or expenditure. Therefore, change in quantity of money can
only bring changes in the price level when it can change the aggregate
expenditure with respect to the supply of output.
If there is no rise in the expenditure, then the demand for goods would not rise
and consequently, the price level would not increase. In case, the expenditure
rises but the supply of output is fairly elastic, then also the price level would
not rise.
Therefore, the impact of change in quantity of money would depend on the
following factors:
a. Effect of change in money supply on level of aggregate expenditure and
volume of production
b. Type of relation between aggregate expenditure and volume of production
The amount of expenditure depends on the consumption function, investment
demand schedule, liquidity preference schedule, and supply of money. An
increase in the quantity of money would decrease the rate of interest.
However, in case the rate of interest is very low, then the increase in quantity
of money would not be able to reduce rate of interest further.
The reduced rate of interest would help in increasing the rate of investment by
individuals, which would further result in increase in income. The increase in
income would increase the aggregate expenditure of a nation. However, when
the increased quantity of money is not able to reduce the rate of interest as it
is already very low, the investment would not show any increase.
Thus, the income and aggregate expenditure would simultaneously fail to
show any type of increase. In such a case, the price level would not rise even
with the rise of quantity of money. However, it is also not guaranteed that if
the increase in quantity of money reduces the rate of interest, then price level
would rise or not.
This is because it may be possible that the proportional increase in price level
is very less as compared to increase in money supply. Therefore, it is hard to
determine relationship between changes in money supply and changes in price
level. This is because they are indirectly related to each other and depend on
aggregate expenditure and elasticity of supply of output.

CONCLUSION:

In an important sense our task throughout this monograph has been to

develop a theory of the nature of money. When asked “What is money?”,
most people respond — quite reasonably — that money is used to buy
something. This gets at money’s use as a medium of exchange, which is of
course the most familiar use. If pressed further, most would also say that
money is something one can hold as a store of value. Indeed, economists
recognize money as the safest and most liquid store of value available, at
least outside situations with high inflation, when money’s value falls rapidly.
Some people will also mention the use of money to pay down debt, with
money used as a means of payment, or means of final settlement of
contractual obligations. Finally, if we ask people “How much is that worth?”
— pointing to just about anything — a common response would be to
evaluate worth in terms of money, this time acting as the unit of
account used to measure wealth, debt, prices, economic value.
At last we would like to thanks our lecturer
for giving us this opportunity and for
encouraging us to finish this assignment on
time.