Ch 1: the relationship between money supply and the

economy activity before the classical theory.

This relation is related about effect of money on the :
1-output and employment

2- income and consumption .

3- interest rate and growth rate .

4- prices level and distribution of wealth .

In the start of past 14 century increased uses of
money in the transactions which exposed the

European economics to rise in the prices level ,

especially in start 16 century when discovery

America , where moved the gold and silver

from usa to Europe . among the writers who
were
In the start of past 14 century increased uses of
money in the transactions which exposed the

European economics to rise in the prices level ,

especially in start 16 century when discovery

America , where moved the gold and silver

from usa to Europe .
 among the writers who were concerned with
high prices level or decline value of money are :

1 – Nicolas oresme ( 1325 – 1382 ) : he is the

first to explain the relationship between
rise the prices and the coins currency parity , if
the currency parity rate falls , the money
supply will increase , hence the prices level will
rise .
2- Nicolas copernic ( 1473- 1543 ) : he is

accepted on the idea the rise in prices

related with the currency quality measured by

quantity of the gold and silver that have of
money example : when the gold quantity is
decline in the money parity , the prices level
increase because rise of money supply .
3- john hales ( 1566 ) : he is accepted on the idea the
rise in prices related with quantity of money .

4- jean Bodin ( 1530- 1596 ) :he is determined that the

price rise depends on the :

a-abundant the gold and silver.

b-monopoly the goods.

C. scarce the necessary goods .

d-reducing the rate of the gold parity in currency .

f-the big increase in expenditures by kingdoms and

presidents of nations . These factors have appositive

relationship with prices , bodin assert on the abundant
of money supply after discover gold and silver in usa
lead to moved gold from America to European and rise
money supply and the prices .bodin made it easy the
road to exist the classical theory .
6- jhon locke ( 1633 – 1704 ) : he is join between
value of money and change in volume of trade ,
where he refer that the price level depends on :

a-Quantity of money , if its rise , the price level well

be increase

b-volume of trade , if its rise , the prices level well be

decrease.

c- velocity of money ( NI / MS) , if its rise , the price

level well be increase.
velocity of money is referred to speed transfer
money from hand to other hand during the
year .the velocity of money is related with
interest rate , if interest rate increase , the
desired hold of money by public will be decline
and rise the velocity of money, the interest rate
is determined through money supply and
money demand .
also explained every the (T.mun ) and ( j. law ) and ( hume ) ,the
price level or value of money is depends on the quantity of money .

but in end 17 century – 18 century , the writers are referring ,that

the price is depends on :

1-Quantity of trade . 2- Quantity of money . if increase Quantity of

trade , the price level will be to decrease , but rise of money supply

lead to rise price level .

Year MS TRADE VELOCITY PRICE
2018 3500 8000 2 0.87
2019 7000 8000 4 3.5
2020 7000 16000 2 0.87
P = M.V /T = 3500*2/8000 = 2

6- Adam smith also is indicated that the value of money is

decreases with any increasing money supply if output
remains constants or the prices will increase with any rise in
money supply ,if money supply rise from M1 to M2 , the
prices will be rise from P1 to P2 .
Ch 2 : The classical theory .

From the writers who built this

theory , they are : ( Adam smith 1723 –

1790 ) , (T. Malthus 1777 – 1834 ) ,( D.R
Ricardo 1772 – 1823 ) , (J S .Mill 1806 ) ,
( Say 1767 – 1832 ) .
1-all these the writers note that the Quantity of

money is the only effect on the price level . the

classical theory includes two things :

1-the classical believes the economy operates at

level in full employment and there is no excess

or shortage in labor forces, and become all the

labor are doing and there is no unemployment

because the wages are flexible
if unemployment occurs , the wages

move to decline and profits is raised and

this lead to high demand for labor until

become supply of labor equal demand

for labor .
2-the output at full – employment or of output is
constant in short run , because factors of
production are at level in full – employment , where
the classical believes there is no excess in
production
because they believes that the economy doing
self adjustment until reaching to equilibrium
between aggregate demand and aggregate

supply . these idea is depends on say law ( the

supply is create demand for it ).
Say said received of money are expending at
direct and Quickly on others products , if stop
the output buying not because of scarce of
money , but it is the goods scarce . the money in
the classical no have bearing return or satisfy ,
but it is medium of exchange between buyers
and sellers .
If government issue money , the new issue are not affect

on the trade because trade or output according the classical

depends on the natural resources without impact of money

on the output or neutrality of money , the real sector are

determined by real factors .

while the monetary sector are determined by
Quantity of money and the prices level , if

money supply increases , then prices will rise

without affect money supply on the
production
there for the classical separated between monetary side and
real side and between the value theory and the monetary
theory.
Monetary sector

General prices level

Real sector or output sector

Full employment labor capital

production
AD = As
3-Determinants of prices :
distinguish the classical between the absolute
prices and the relativity prices , the absolute
price are indicate to general prices level
determined by Quantity of money (M*V) , V =
Y/M ,
the relativity prices is explaining the market
prices for goods and services , then determined
by real supply and demand ,
where :
a-The demand side included ( consumer ).

b-The supply side included (producer ) .

the parity rate between goods are depends for

compare between costs of production , especially
for hours number included in produce of goods ,
Good A produce = 2 hours , b produce = 1 hours ,
the price A = 2 B , the labor is labor plus capital
and primary materials .
4-the role of money in the classical theory :

Function of money in the classical is medium of

exchange and as a measure the economic values

( say

) benefit from money derivation from the goods

benefit that gets by money , the received for
money will be move to expending on the goods
and services at directly .
all received from money will be spent without

existence gap between receive of money and it is

spend or the classical excludes the time from the

economic analysis and cancel hoarding by individuals ,

this meaning un affect hoarding on the shortage in
demand , so the classical attentions for money supply
without money demand .
5-the relationship between money supply and
the prices.

The classical believes existence relationship

direct and symmetry between MS and P , if
increase MS 10% , the price level rise 10% ,
with at assuming the production is constant .
6-determinantes the money supply at the classical :
Ricardo indicate the money supply are consistent
from :

a-money is consists from gold coins and paper money

able convertible to gold in c. bank .issue of money in
this case are subject to covering from the gold at
percentage 100% , then the currency is protect from
drooping or change in money and price happen in
following form increase gold by the mines output ,rise
the gold reserve and money supply and the prices
level.
But on the international level ,nations that hold
high of gold exposed to rise in price level ,
while , nations that hold low gold exposed to
low price level , this process is affect on the

gold export and import.

B-paper money not able convert to gold , these
currency are issue by government and it is rise
price level . based on previous observations , the
real output not impact on the money supply and
price level and change in Y and MS are
determined by separate factors .
7- j.s Mill is tried to develop new analysis in the
mid - half 19 th century through introducing
new ideas , such as the velocity of money and
hoarding and commercial banking credit . the

relationship between price and (MS )and(V) are

positive , but this relationship with banking
credit also positive and hoarding are negative .
The new idea in Mill , it’s the banking
credit , as the expansion in banking
credit ,will be increase the demand for
goods and services and its increases
the price level , this situation occur

even if not the money supply does not

increase.
7- j.s Mill is tried to develop new analysis in the
mid - half 19 th century through introducing
new ideas , such as the velocity of money and
hoarding and commercial banking credit . the

relationship between price and (MS )and(V) are

positive , but this relationship with banking
credit also positive and hoarding are negative .
8-the positive relationship between money
supply and aggregate demand:
within assumption the money as medium of
exchange and ignore the hoarding and assume
the velocity of money constant ,the Quantity of
money become actress to aggregate demand ,
AD = F ( MONEY SUPPLY ) and there for
aggregate demand depends on the Quantity of
money and thus the Quantity theory becomes
theory of aggregate demand
In the figure (1) , under assumption constant of production ( Y) ,
increase money

supply lead to rise AD from AD1 to AD2 and price rise from p1 to
p2 , P = F ( AD ).
Ch3 : The Quantity theory in money for fisher .

This theory includes methods two :

1-The transactions approach : fisher theory is the best
one that contributed to explain the fisher famous
exchange equation .and this approach can be
formulated in the following equation :
M*V = P * T , where , M =money supply , V= velocity of
money , P= price , T =Quantity of trade or output .
This equation shows two aspects :
a- The money side ( M*V ) : its money multiplied by the
speed circulation of the money , M*V is the total amount of
money in the economy or the amount of spending in the
economy , M*V is referred to the monetary value of the
transactions volume during the year . the two sides of the
equation are equal , so this equation becomes identical
this equation indicates that the change in the amount of money
leads to change in the prices level and the same the proportion
between them .
This theory presupposes the stability of each T and V in short -
terms. The T is determined by material factors , including :
A- the available real resources b- efficiency , c-
degree of integration between firms d- sale of
final goods , and no effect by the monetary
factors. in addition , this theory assumes that the
change in M . V and P don’t affected by T . This
theory neglected the time idea from the economic
analysis .
The demand side for its effect on T and its
assumed fixed V , although its influenced by
other factors , such as , interest rate and
prices , where increase interest rate and
prices level leads to rapid circulation of money
.
P = M*V*/ T*

P = f( MS )
B - The commodity side : includes , the sale of final goods and re
sell used goods and the sale and purchase of securities multiplied
by their prices ( T * P ) . in each economic process , there is
relationship between the value paid and the value received , the
value paid by the buyer equals the value of the commodity
received by him , T = 5000 . P = 1.5 , national income (Y ) = 5000 *
1.5 = 7500 Dinar .
2- the equation of exchange in form of income : the quantity
theory can be formulated in form of income by the following
equation :
M * V= P * y , V= P * y / M ,where , P * y = national income ( Y
V= Y / MS , exam : y = 5000 , p = 1.5 , Ms = 3000 , V = )
5000*1.5/ 3000 = 2.14.
This equation is more convincing compared to the previous equation
and its also closer to the conceptions of the cash –balance theory for
Cambridge school that will come later. If (v ) constant and y is
determined by real factors , any change in ( MS ) is lead to change in ( p
). we conclude from the above that fisher see the prices are linked
positive relationship with ( M , V) and its with negative (T or output ) or
that value of money is related relationship negative with ( M , V ) and
positive with ( T) . Where the Value of money = 1/p
The influencing factors on the equation of
exchange according to fisher M*V = T *P :
First-The influencing factors on the (T) ,
includes :
1- The influencing factors on the producers
activity, includes :
a-Quantity of natural resources
b- division of labor
c- technology and advance in innovations
d- the capital accumulation .
2- The influencing factors on the consumers activity, included:
a- different the needs
b- the size of needs .
3- The influencing factors on the consumer's and the producers
activity, included :
a-development of transport
b- freedom of trade
c- development of monetary and banking system
d- confidence in trade . if these factors are appropriate , the size
of output and trade are increasing and the domestic prices level
will be drops .
second - The influencing factors on the (v ) , included :
1-behavior of public with related:
a- saving ( deposits ) and hoarding
b- uses the credit cards in transactions
c- uses the checks and electronic money in payment .
2-the payment system with related:
A-frequency of receipt and expend of income
b- degree of regularity between of receipt and expend of income
c- harmonization between receipt and expend of income in
respect of timing and the size.
3 – General reasons, included:
a-The population density
b - the transport quickly. if these factors there
are suitable and positive , they will increase
(v) and the price level will rise .
Third : The influencing factors on the (MS) ,
included :
1-import of gold .
2-coinage of currencies
3- the gold production
4-issue paper of money , if these factors increase
, the money supply and velocity will be rise and
the prices will be rise .

P = M V / T , M V* = P T* , P = F (MS).M = 5000 .
V= 2 , T = 20000 , Find the p 2 *5000/20000
=
This theory shows only money supply is affect on the price level,
however the effect other factors on the price level was not show , for
know the relationship between money supply and the prices , fisher
assume :
1- constant of trade , , that any increase in money supply does not rise
production , because the output depends on the amount of natural
resources and there for money supply does not affect on the
production .
2- constant the (v) , because its depends on the density of
population and speed transport , development of banking habits ,
payment system in the country , and there for constancy each ( V)
and (T) , makes the prices affected only by money supply and the
relationship between these factors are positive and proportional.

P = M V*/ T* or P = F ( MS ) .
New trends about important of money in economy in (wick sell
1851- 1926 ) :
wick sell is from the Swedish school , he came up with new
counter – analysis of the classical that came from (hum ,
Ricardo , fisher ) , wick sell analysis is based on the following
ideas :
1-The impact of interest rates on the prices level.
2-cancel idea the separation between the monetary theory and the
value theory or converter the relative prices in to monetary prices
through application idea demand and supply in determined the
prices level .
3-refused idea neutrality of money and the equilibrium between
demand and supply according to (say) .
4- He gave great important to money in economic activity as
medium of exchange and store of value.
5-sees that the price is determined by the total demand and total
supply , where he explained that the components the demand and
supply :
AD included : demand for consumer goods and services ( c ) plus
demand for liquidity (i) for purpose investment or Md = C+ I ,
whereas aggregate supply , included : supply the consumer
goods and services (C) plus the supply the liquidity (S) or
aggregate supply = C + S . and there for the equilibrium in the
economy is determined by equal demand for the consumer goods
and services and demand for investment (c + I ) and supply for the
consumption goods and services and liquidity C + S .
C+I=C+S.
I = S , if (I )more than s , become AD more than AS and rise ( p)
To explain imbalance in the economic, wicksell distinguish
between types interest rate two :
1- Money interest rate : its interest rate in monetary market , its
determined through the reserves supply and reserves demand .
the reserves supply is depends on the saving.
2-real interest rate is called the natural return , wicksel say , the
real interest is the expected return from the real capital or the
real return of the product capital .

.
Important the r% in determine the price level and disequilibrium in
economy:
wicksell distinguish between the real interest rate and the Money
interest rate in determine the (p) as follows :
1-if the real interest rate more than the Money interest rate , in this
state increase the capital return and become more than from cost
of borrowing , will be increase profit and demand for loans , under
assumption Y in full employment any increase investment will be
lead rise price level and become AD more than AS .
2- if the real interest rate less than the Money interest rate , in this
state decrease the capital return and become less than from cost
of borrowing , will be decrease profit and demand for loans ,
under assumption (Y ) in full employment any decrease
investment will be lead drop in price level and become AD less
than AS .

.
Wiksell show , that commercial banks must be management
r% to keep on the stable price level through achieve the equal
between money interest and real interest rate .
Conclusion from above , the un stable in prices level not
related at money supply but also on the real factors (
expected investment return ) and the affect money supply on
the economy is it their affected on the money interest rate .
Evaluation of transactions theory :
1-this theory is based on the high un realistic assumptions,
determinant of the price level is the quantity of money and others
elements in equation of exchange are constant , constant T and V
un realistic assumption , it has bee experienced change in v are of
great important than changes in money , such as higher inflation
in Germany in 1928 was not much the increase in MS , but increase
V , every body tried to spend rapidly before depreciating mark as
quickly .
2-fisher assumed affixed relationship between currency and
deposits, but increase of currency will be increase their demand
proportionally , but its not proved or correctly a whole , such as
during great depression , deposits in usa fell 35 % from 1929-
1933 , while currency out side bank rose by 30% , also rising
prices incentives business expansions and arise in p my tend to
raise T , Thus appositive causal factor in fluencing T ,V and MS .
3-this theory assumes that V independent of change in M and P ,
but all the elements in equation are inter-related .
4-fishers transactions is limited to the long – run analysis , but T, v
are fluctuating , fisher is said such period were temporary in nature
and long – run more normal relationship would hold , theory will
have a little validity .
5-the equation M V = T P is identity , it dos not provide causal
explanation for changes in the value of money " it indicates only
the final stage of rise in the price level.

6- equation suffers from some Inconsistencies , M refers appoint

of time , where as , V refers to the turnover of money during a
period of time , thus M .V involves the inconsistency .
7-T ,V,don’t help much to explain the level of NI , which measures
Aggregate expending on final products only .
8- there are un employed resources , if rise quantity of money would
lead to increase in output and it not affect on P , but in full
employment change in MS will affect on P or the equation theory is
correct in the state full employment only .
9-the P does not depend upon the factors included in the
equation, price may be caused by factors out side the
equation , differentiation of human wants , diversification of
industries and facilitation of transport would lead to increase
of volume trade and decline price level .
10-this theory emphasizes the role MS in determining the P ,
keynes referred that the changes in MS and P depends upon
some more factors , such as , income , expenditures , saving
and investment , rise P may because growth of population
lead to fall in per – capita output and real income .
11-the theory relates to money in circulation, but people do keep
some money as balance for future Thus , money is not spent
directly , it regards money only as a medium of exchange and
ignores its important role in society as a store of value , it also
ignores the factors determining the demand for money .
IF DD =10000 , rd = 500 , rt = 1000 , c =2000 , e = 4000 , td = 20000 ,

Price = 1.5 , y or trade = 20000 , find

M1= 1+C /rd + c + e * MB .

M1 = 1+0.2 /0.05 + 0.2 + 0.40 * 6500 =1.8* 6500 = 11700.

M2 =1+C+A /rd + art +c+e ,, M2 = 1+0,2 + 2/0,05 + 2 ( 0,O5 ) +0.2 +0.40.

=3.3 *7500 = 25263

V = Y / M , 30000 /11700= 2.5

MD = 11700 / 30000 = 0.39 ,

Ch5 : Keynes and modern quantity theory about role
of money in economy:

1-keynes is link between the price level and money

supply and money demand .

The relationship between money supply and the

price is positive, while this relationship between
money demand and the price is negative.
Keynes equation

*P = n / k+r k

N= MS , K = Md , r = requirement reserve , k* = deposits .

this equation explained the relationship between price level

and money demand and requirement reserve is negative. .

but it is positive with money supply (ms). Keynes assert on the

(k) and ( k*) in its impact on the price level .
 Keynes is show , the (N) and ( r) •
can be governing by central bank .

while ( k) and (k*) not control by •

central bank because these variables
are depending on the public behavior
, there fore the stable in prices is
subject to stable in ( k , k*).
The stable in ( k , k * ) are depends on the
rediscount rate , if increase ( k * ) , the central
bank can be decrease rediscount rate for
encourage the demand for loans .

but keynes is suggests make changes in ( n )

and r % for the purpose influencing on the ( k )
and (k *) .
2-the equilibrium in the economic system and stable in •
the price level :

The stable in price level is happen , if : •

I = s and 2. the absence of the emergency profits. •
3. market interest rate = real interest rate •
Keynes distinguish between types two from interest rate : •

1 – market interest rate is determined by commercial •

banks.
2- real interest rate is the market return on the •
investment .
Keynes show , if money interest rate less than real interest
rate , the demand for loans is upward , this can be
illustrated

With the following diagram:

Expansion credit policy

Increase money supply by make the loans

Emergency profits create

more rise in output and employment

rise prices level

3-opinions Keynes about effect of money on the prices
:

a- P = f ( Y, out put )
where : Y = AD , out put = AS

P = Y / output , if Y = 8000 , output = 6000 , so p =

8000 / 6000 = 1.5.

b- absence of a causal relationship between money

supply and total demand :
in the classical theory , the change in money
supply equal change in price .

but in keyens , this relation is not positive and

proportionality because money supply affect
on the total demand through change in the
interest rate .
4-the relationship between (MS ) , ( MD , r% ) .

1-when Ms = 0 , rise Md lead to increase interest rate , this means

in this the case increased money demand by individuals , the
interest rate must be raised to persuade individuals to deposits
their funds in banks or purchase of bonds .

2- but if it was Md = constant , rise money supply lead to decrease

in interest rate .
5- r % , marginal efficient of capital and investment :

Investment is depending on the factors two :

a-money interest rate . b - marginal efficient of capital ( real interest rate ) .

interest rate is affect on the investment and turn the investment affect on the
marginal efficient of capital .
if marginal efficient of capital is constant , the investment rise with
decline interest rate .:
6- investment and total income and effective demand :
Keynes indicated that the increase in the investment leads
more rise in total income and employment through
make multiplier of investment.

Multiplier (m) = 1/ 1- mpc.

Change Y = m* change (i)

7- Money supply and the prices level : the Keynesians

shows, that changes in money supply leads changes in the
price but indirectly through affect on interest rate on the
investment , employment , income and output and the
aggregate effective demand .
according to Keynes , money supply determines
aggregate effective demand through :

1- Marginal efficient of capital.

2- Interest rate.

3-the consumption function.

C= a +bY
In all of these cases ,change in money supply may be
change in (AD) .

8- assumptions of Keynes model:

a-all the resources the employees are
homogeneous and able
substitution .
B-return factors of production are constant.

c- factors of production are receive the same of

wages.
9- Reasons increase the costs and
prices :

a-increase the bargaining of workers

lead to rise in wages without
increase in their productivity.
b- operation law of diminishing
return in short – run .
C-Existence bottlenecks in production due to
perfectly inelastic in supply of resources
d-non homogeneity of resources .
but price according to Keynes not change at
proportional with MS and with change in
effective demand .
9-keynes distinguish between that case two
with related affect (AD ) on the ( P) :

a-full – employment in factor of production ,

any increase in the effective demand lead to
rise in ( p ) and not rise in production or
employment . .
b- un full – employment in factor of production,
any increase in the effective demand lead to
rise in production or employment and not rise
in ( p ).,
The modern quantity theory :

This theory are developed by Milton Friedman , where

he explained the change in (p) is depending on :

1- ( MS) 2-the fluctuations in agriculture production ,

3-distrust in domestic currency , 4- monopoly 5- rise
prices of goods , 6- raise profits by corporations
owners ..
Also he show existence other factors that affect on the (p) are :

P = f ( output , k or Md ). Where : output = production , k = money

demand :

a-if Ms is constant ,rise in output lead to decline in price .

b-the liquidity preference (k)refers to the money demand by

individuals for the purpose of holding it .
Friedman is show money demand is stable
in long run and it is depends on factors
three :

1-the real income level ( wealth) ,if it is

increases , the ( k ) tend to rise , but
Friedman show the (k) increase more than
the rise in the real income in usa.
2-cost held of money : cost held of money is depend
on the interest rate on other assets , such as bonds ,
stocks , if interest rate increase on bonds , the (k) was
become low , because , the opportunity cost to held of
money becomes high .

3-inflation : rise in price level its causes decrease in

value of money and down ward in money demand.
The major results to the theory of quantity :

1- stable in price is required to achieve tradeoff

between money supply and production and
population growth rate.

2-The hyper in MS lead to inflation , but Ms at low

rates lead to depression in economy. it must be
achieve growth in money supply ranges between 3% -
5% for avoid the inflation .
3-impact the monetary policy on the inflation is
involve lag time or the monetary policy come
their results after period time
Keynesians vs monetarists approach :Following the
differences between the Keynesians vs monetarists
about the relationship between money supply and the
economic activity :

1- Keynesians believes interest rates are linked

between money supply and aggregate demand , while
monetarists are asserts there are number of rates of
return ( including interest rates ) which linkage the
money supply with ( AD ).

the change in money supply affects on the rates of

return assets , which turn affect on the ( AD ) ,when AD
is changing , its affect on the GDP .
2- Keynesians are believes that Ms has only
indirect effect on the( AD) ,
but monetarists assert that it has both direct and
indirect effect on ( AD ) .

3- Keynesians views in long run ,change in ( MS)

has affect both price and output, when economy
is operation below full employment , but change
in ( ms) will affect only on the (p) when the
economy has reached to full employment .

Monetarists are considering increase money

supply as necessary and sufficient condition for
rising prices level.
4- Keynesians says the relationship between
change in (MS) and national income is unstable, but
Monetarists , claim that this relation is stable .

5- Keynesians believes that relationship between

change in (MS) and national income quite long run ,
Monetarists says that its quite in short run .