cfm 302. monetray theory policy

7/24/2019 Cfm 302. Monetray Theory Policy

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CFM 302: MONETARY THEORY AND POLICY

CFM 302: MONETARY THEORY & POLICY


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Copyright

All rights reserved. No unauthorised reproduction of this manual or part thereof in any

form is allowed.


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BUSS 101/CFU 102 : INTRODUCTION TO MICRO-ECONOMICS

About this STUDY MANUAL

CFM 302, MONETRAY THEORY & POLICY, has been produced

by KCA University. All Modules produced by are structured in the

same way, as outlined below.

How this STUDY MANUAL is structured

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What you will already need to know.

What you can expect from the course.

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The overview also provides guidance on:

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Where to get help.

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Activity icons.

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We strongly recommend that you read the overview carefully

before starting your study.

The course content

The course is broken down into CHAPTERs. Each CHAPTER

comprises:


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An introduction to the CHAPTER content.

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New terminology.

Core content of the CHAPTER with a variety of learning

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you with a list of additional resources at the end of this STUDY

MANUAL; these may be books, articles or web sites.

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MODULE TITLE: CFM 302-F MONETARY THEORY AND POLICY

Introduction

The Introduction to Monetary theory module deals with the theoretical and practical

framework of the economy.It is a descriptive economic theory that details the procedures

and consequences of using government-issued tokens as the unit of money, i.e., fiat

money.According to Modern Monetary Theory, "governments with the power to issue

their own currency are always solvent, and can afford to buy anything for sale in their

domestic unit of account even though they may face inflationary and political

constraints".

Monetary Theory and policy aims to describe and analyze modern economies in which

the national currency is fiat money, established and created exclusively by thegovernment. In Monetary Theory and Policy, money enters circulation through

government spending. Taxationand its Legal Tenderpower to discharge debt establish

the fiat money as currency, giving it value by creating demand for it in the form of a

private tax obligation that must be met using the government's currency. An ongoing tax

obligation, in concert with private confidence and acceptance of the currency, maintains

its value. Because the government can issue its own currency at will, Monetary Policy

maintains that the level of taxation relative to government spending (the government's

deficit spendingorbudget surplus)is in reality a policy tool that regulates inflation and

unemployment, and not a means of funding the government's activities per se.

The first part of this writing introduces students to the evolution of money. Students

should be able to understand the need for and supply of money in the economic system.

Secondly having obtained the theoretical background of monetary policy, students will be

introduced to the fluctuations in the value of money with specific reference to the Kenyan

situation. Students should be aware that there are changes in the value of money

depending on the economic situations in the country. Thirdly the students will be

introduced to the quantity theory of money which covers the Fishers approach,

Cambridge and Income theory and investment approach Lastly, general monetary policy

for developing nations and theories of interests will be examined in detail. At the end of

each topic, there are self-test questions and activities to enable you understand the topic

further.
http://en.wikipedia.org/wiki/Fiat_moneyhttp://en.wikipedia.org/wiki/Fiat_moneyhttp://en.wikipedia.org/wiki/Fiat_moneyhttp://en.wikipedia.org/wiki/National_currencyhttp://en.wikipedia.org/wiki/National_currencyhttp://en.wikipedia.org/wiki/Taxationhttp://en.wikipedia.org/wiki/Taxationhttp://en.wikipedia.org/wiki/Legal_Tenderhttp://en.wikipedia.org/wiki/Legal_Tenderhttp://en.wikipedia.org/wiki/Fiat_moneyhttp://en.wikipedia.org/wiki/Fiat_moneyhttp://en.wikipedia.org/wiki/Deficit_spendinghttp://en.wikipedia.org/wiki/Deficit_spendinghttp://en.wikipedia.org/wiki/Budget_surplushttp://en.wikipedia.org/wiki/Budget_surplushttp://en.wikipedia.org/wiki/Budget_surplushttp://en.wikipedia.org/wiki/Budget_surplushttp://en.wikipedia.org/wiki/Deficit_spendinghttp://en.wikipedia.org/wiki/Fiat_moneyhttp://en.wikipedia.org/wiki/Legal_Tenderhttp://en.wikipedia.org/wiki/Taxationhttp://en.wikipedia.org/wiki/National_currencyhttp://en.wikipedia.org/wiki/Fiat_moneyhttp://en.wikipedia.org/wiki/Fiat_money


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Objectives

By the end of this unit you should be able to;

Explain the scope and rationale of monetary theory and policy

Describe the demand for and supply of money in an economy

Differentiate between the theories of money

Identify the need for interest

Advice on the suitable monetary tools and techniques for a developing economy.

Contents

1.0LECTURE ONE: INTRODUCTION TO MONETARY POLICY............................3

1.1.1

Introduction.......................................................................................................31.1.2 Specific objectives.........................................................................3

1.1.3 Evolution of money...........................................................................................4

1.1.4 Functions of money...........................................................................................5

1.1.5 Qualities of a good money................................................................................6

1.1.6 Role of money in different economic systems..................................................8

1.1.7 Lecture activities...............................................................................................8

1.1.8 Self-test questions.............................................................................................9

1.1.9 Summary of the lesson.....................................................................................9

1.1.10 Further Readings..............................................................................................9

2.0LECTURE TWO : DEMAND FOR AND SUPPLY OF MONEY...............................10

2.2.1 Introduction....................................................................................................10

2.2.2 Specific Objectives.........................................................................................10

2.2.3 Demand for Money........................................................................................11

2.2.4 Transactional Demand for money..................................................................12

2.2.5 Keynesian approach to the Demand for money............................15

2.2.6 Supply of Money .........................................................................16


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2.2.7 Components of Money supply.......................................................18

2.2.8 Items excluded in the money supply..............................................18

2.2.9 Determinants of money supply......................................................20

2.2.10

Lecture activities............................................................................23

2.2.11 Self-test questions..........................................................................23

2.2.12 Summary........................................................................................23

2.2.13 Suggestions for further reading......................................................23

3.0LECTURE THREE : THEORY OF MONEY AND PRICES................................. 25

3.3.1 Introduction ....................................................................................25

3.3.2 Specific objectives...........................................................................26

3.3.3 Quantity theory of money...............................................................26

3.3.4 Transaction approach.....................................................................27

3.3.5 Fishers equation of exchange.........................................................27

3.3.5 Assumptions of the Fishers theory.................................................30

3.3.6 Criticism of the Quantity theory of money...................................31

3.3.7 Lecture activities..........................................................................33

3.3.8 Self-test questions........................................................................34

3.3.9 Summary.....................................................................................34

3.3.10 further readings..........................................................................34

4.0 LECTURE FOUR: CASH BALANCE APPROACH TO THE QUANTITY

THEORY OF MONEY............................................................................................35

4.4.1 Introduction ..................................................................................36

4.4.2 Specific objectives.........................................................................36

4.4.3 Equations of the Cash Balance Approach......................................38

.4.4 Criticism of the Cash Balance Approach...........................................40

4.4.5 Comparison of Fishers Approach with the Cambridge Approach..40

4.4.6 Lecture Activities...........................................................................44

4.4.7 Self-Test questions.........................................................................44

4.4.8 Summary.........................................................................................45

4.4.9 Further readings............................................................................45


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5.0LECTURE FIVE : KEYNESIAN VIEWPOINT ON THE QUANTITY THEORY OF

MONEY ..................................................................................................................46

5.5.1 Introduction ....................................................................................46

5.5.2 Specific Objectives..........................................................................46

5.5.3 Motives why people hold wealth as money rather than as interest

bearing securities........................................................................................47

5.5.4 Total demand for money...................................................................52

5.5.5 Keynesian view on interest rates and money supply and

demand.......................................................................................................53

5.5.6 Effects of an increase in the supply in the Keynesian view

point..........................................................................................................54

5.5.7 The Monetarists view point.............................................................55

5.5.8 Limitations of the Monetarist..........................................................56

5.5.9 Implications of the Keynesian and Monetarist theories for economic

policy..........................................................................................................57

6.0 LECTURE SIX: INCOME THEORY OR SAVING INVESTMENT.......................60

6.6.1 Introduction.........................................................................................58

6.6.2 Specific Objectives..............................................................................59

6.6.3 Explanation of the Theory..................................................................60

6.6.4 Importance of the Saving Investment Theory....................................62

6.6.5 Learning Activity...............................................................................63

6.6.6 Self Test Questions............................................................................64

6.6.7 Summary.............................................................................................64

6.6.8 Suggestions for further reading...........................................................64

7.0 LECTURE SEVEN: MILTON FRIEDMANS VERSION TO THE QUANTITY

THEORY OF MONEY................................................................................................667.7.1Introduction.................................................................................... 66

7.7.2Specific objectives.............................................................................67

7.7.3 Determinants of demand for money................................................68

7.7.4 Wealthholders demand for money................................................69

7.7.5 Demand for money by business firms.............................................69


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7.7.6 Conclussins......................................................................................70

7.7.7 Lecture activity................................................................................70

7.7.8 Self test questions............................................................................71

7.7.9 Summary .........................................................................................71

7.7.10 Suggestions for further reading......................................................71

LECTURE EIGHT: MONETARY POLICY................................................................72

8.8.1 Introduction.....................................................................................72

8.8.2 Specific objectives...........................................................................73

8.8.3 Objectives of monetary policy.........................................................74

8.8.4 Instruments of monetary policy........................................................76

8.8.5 Limitations of Monetary Policy.......................................................77

8.8.6 Lecture activity................................................................................78

8.8.7 Self-test questions............................................................................78

8.8.8 Summary .........................................................................................78

8.8.9 Suggestion on further reading..........................................................78

LECTURE NINE: FLUCTUATIONS IN THE VALUE OF MONEY.........................79

9.9.1 Introduction......................................................................................79

9.9.2 Specific objectives............................................................................80

9.9.3 Inflations and its different Forms.....................................................819.9.4 Inflationary Gap...............................................................................84

9.9.5 Wiping out Inflationary Gap............................................................88

9.9.6 Causes and effects of inflation..........................................................89

9.9.7 Measures to control Inflation............................................................97

9.9.8 Deflation.........................................................................................100

9.9.9 Causes.............................................................................................101

9.9.10 Effects of deflation.......................................................................103

9.9.11 Measures to check deflation..........................................................105

9.9.12 Lecture activities...........................................................................106

9.9.13 Self-test questions.........................................................................106

9.9.14 Summary.......................................................................................107

9.9.15 Suggestion for further reading......................................................107

LECTURE TEN THEORIES OF INTEREST...............................................................114


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10.10.1 Intriductiobn...............................................................................114

10.10.2 Specific objectives......................................................................114

10.10.3 Theories of interest.....................................................................114

10.10.4 Determination of interest rates....................................................117

10.10.5 Lecture activity...........................................................................125

10.10.6 Self-test questions.......................................................................125

10.10.7 Summary.....................................................................................125

10.10.8 Suggestion for further reading....................................................126

LECTURE ELEVEN: CREDIT CREATION AND CONTROL...................................12711.11.1 Introduction................................................................................127

11.11.2 Specific Objectives.....................................................................12711.11.3 Quantitative methods of credit control......................................128

11.11.4 Qualitative methods of credit control........................................134

11.11.5 Learning activity........................................................................139

11.11.6 Self-test questions......................................................................140

11.11.7 Summary....................................................................................140

11.11.8 Suggestion for further reading...................................................140

LECTURE TWELVE: BANKING SYSTEM..............................................................141

12.12.1 Introduction...............................................................................141

12.12.2 Specific objectives.....................................................................142

12.12.3 Central Bank..............................................................................143

12.12.4 Central bank changing role........................................................144

12.12.5 Money and Capital market........................................................144

12.12.6 Financial intermediaries.............................................................145

12.12.7 Commercial Banks and its Functions........................................145

12.12.8 Role of non-banking financial institutions.................................147

12.12.9 Lecture activity..........................................................................147

12.12.10 Self-test questions....................................................................147

12.12.11 Summary..................................................................................148

12.12.12 Suggestion for further reading................................................148


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1.0 LECTURE 1: INTRODUCTION TO MONETARY THEORY AND POLICY

1.0 Introduction

Welcome to the first Lecture of Introduction to Monetary theory and Policy. This lecture

covers definition of money, evolution of money, features or qualities of good money,

functions of money and money in different economic systems. We will start by defining

what money is and what to be considered as money.

1.1 Lecture Outline

1.1.1 Definition of money

1.1.2 Evolution of money

1.1.3 Functions of money

1.1.4 Features of a good money

1.1.5 Role of money in different economic system

1.1.1 Definition of money

Money is a commodity which is universally accepted in exchange of all other

commodities with no intention on the part of the receiver of using it in part of the

received of using it in any other way than to effect further exchanges. Thus money is a

commodity that facilitates exchange of commodities.

medium of exchange: a medium of exchange issued by a government or other public

authority in the form of coins of gold, silver, or other metal, or paper bills, used as the

measure of the value of goods and services

1.1.1 Specific Objectives

At the end of the lesson you should be able to; Define the term money.

Explain the various evolutionary stages of money.

Identify the qualities of a good money

Outline the role of money in different economic systems


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1.1.2 Evoluti on of money

1. Commodity Money

In barter trade commodities were exchanged for commodities e.g. one goat for a

sack of maize. With time certain commodities were identified by communities

and used as medium of exchange e.g. beads, hides and skins, tobacco, cowrie

shell etc. Those identified commodities functioned as basic money. To serve as

money the conditions needed to be easily verifiable, transportable and divisible

and also easy to store.

2. Metall ic Money(Real Money)

Commodity money posed the challenge of being bulky and inconvenient, unstable

in value and some were perishable and so could no longer serve as standardized

medium of exchange. The communities identified metals such as bronze, copper,

silver and gold to act as money. These came to be known as metallic money. The

metals were not easily available

Coins minted were full bodied. The monetary value of the metal was equivalent

to the commercial value of the material it is made of (had intrinsic value)

3.

Coinage Money

As trade developed, metallic money became more refined as metals were minted

in appropriate sizes and quantities of coins to act as standard medium of

exchange. Coins are portable, divisible, durable, mintable and their value does

not fluctuate considerably. Owing to high demand metals become rare to obtain.

Their weight of value was guaranteed by competent authority.

4. Paper Money

The receipts given out by goldsmiths to merchants and other who deposited gold

and other metals for safe custody, acted as paper money. The holder of such

receipts (that acted as I OWE YOU (IOU) would make payment by signing the

receipts at the back. The holder would present the receipts to a goldsmith if he

wanted the gold. These receipts became bank notes with time as people showed


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confidence in them. As 1st time bank notes/receipts were not considered as

money but acted simply as an acknowledgement of a bankers debt (IOU). As

time went by paper money became popular as more and more people were willing

to accept it even it could not be converted into gold or silver. This is the origin of

the banking principle as applied today. Paper money is referred as legal tender

(currency notes and coins that are accepted for their printed face value because of

the law)

5. Representative Money(Credit money)

(Legal tender refers to currency notes and coins that are accepted for their printed

face value because of the law).

The legal tender is inconvenient and ..to use where large transactions

are involved. This led to the development of other forms of paper that perform

the functions of currency money (represent currency money held elsewhere e.g.

cheques, promissory notes, credit cards etc.

Evolution of money (diagrammatically)

Barter Commodity Metallic Coinage Paper

Credit Money

1.1.3. Functions of Money

1. Medium of Exchange: Individuals sell their goods for money and later on

they use this money to buy some other goods. It allows the seller to sell goods

in unfinished state and the buyer to make factional purchases.

2. Money as a Unit of Account: The monetary unit of account is used to

measure the value of foods and services in the economy, added and accounts

kept. Money is thus the yardstick that allows the individuals to measure the

relative value of goods and services. The issue of money as unit of account

has greatly reduced transaction costs to the time effort and expenses that go

into the purchase or sale of goods.

3. Measure of value: The prices of different goods are indicated in terms of

money. It is easy to compare the relative values of commodities which are


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dissimilar and entirely different from one another. The values are in

proportion to their respective prices.

4.

Store of value:Money enables one to keep portion of his assets liquid to beused as and when the need arises. An individual can save some part of their

income during young age and use it during old age. Thus money helps

individuals to keep some money reserves for future transactions.

5. Standard of Deferred Payments: Money is used to make future credit

transactions. It makes borrowing and lending less risky by acting as standard

measure of payments overtime.

6.

Transferri ng immovable Property:An owner of a house, for instance can sell

the house in one geographical location and buy another house in another

location, thus transferring the value of the house through immovable.

1.1.4 Qualities/properties /characteristics of good money

To adequately perform the above functions money must possess the following qualities:

1. Scarcity: Money need not have any intrinsic value (useful as a commodity but it

must be scarce. That is to acquire money there is some opportunity cost. The

scarcity of money contributes to the stability of the value of money.

2. Stabil ity of value:Money should be stable in value for it to be used as standard to

measure the value of all other commodities.

3. Durability: For money to act as store of value it must last for a long time i.e.

should not die, wither away or be easily defaced.

4.

Portability: Money should be easily transportable from one place to another

without depreciation. It should have a large value in small bulk so that is it

convenient to carry.


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5. Homogeneity: For money to act as unit of account different units of money

material should have the same value. The material should be having informed

quality and capable of standardization.

6.

Acceptability: For money to act as a medium of exchange (in exchange of all

goods and services) it must be acceptable to all without hesitation.

7. Divisibility: Money must be divisible into small units, to enable people undertake

all types of transactions, without loss in its value.

8. Cognoscibility: Money should be easily recognized by those using it to effect

exchanges.

9.

Malleability: Money should be capable of being moulded into given/required

shapes and be stamped.

1.1.5 Role of money in different economic systems

Capitalist economy

The capitalist economy recognizes the right of individual property. It is free from all

government control. All factors of production are controlled, owned, and operated by

private entrepreneurs. The owner of the property in a capitalistic economy can use his

property, according to his own choice. The price is naturally guided by the price

mechanism i.e. before taking up any economic activity, a businessman or an

individualist it considers the cost, prices and the rate of profit. He therefore engages

in various productions which may produce good return. Thus profit motive is the

prime factor in capitalistic economy. Capitalistic cannot function without price

mechanism and price mechanism cannot function without money. Thus money is the

life blood of capitalistic economy, hence;

Consumer can make a rational choice of goods.

Production decisions are based on money

Money simplifies the distribution system

Decision regarding saving and spending

Price mechanism regulates the flow of investment


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Money is the basis of credit

Socialistic economy

All economic activities are planned, controlled and guided by the government or its

agencies. No free market and no right of property to individuals.

Q1, Do you think money has any role to play in economy?(Marx believed that money is

the root cause of exploitation of labour by the capitalists, socialist can work without

money i.e. goods exchanged for goods)Leon Trotsky in 1921 realized that without a firm

monetary unit, commercial accounting only increases chaos All commercial

transactions are carried on in money though money occupies an inferior and subordinate

position in the economy. Even in a socialist economy cannot work without money. Hence

money;

Is a guide to economic activities

Allocation of resources

Distribution of income

Planned Economy

A planned economy is generally followed in underdeveloped countries where there is no

shortage of real / natural resources. The need is only to tap those resources in a planned

manner. The state takes the responsibility for the development of these dormant resources

through agencies or private enterprises but under the guidance of the government. The

development of the economy needs or tapping of natural resources needs monetary

resources whish are in plenty and the government has to provide to activate the real

resources

The government of such a country taps all the possible sources of monetary resources to

carry out development plans. For this purpose the government collects money through

taxes, borrowings from inland and foreign sources and deficit financing. The government

in a planned economy therefore controls the imports and exports and internal transactions

to keep a balance in the economy. Thus money plays important role in a planned

economy.


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1.1.6 Lecture Activities

Explain the evolution process of money

Identify the core qualities of a good money

Discuss wh barter trade still exist in some arts of the countr ?

1.1.8 Summary

In this lesson we have learnt that:

Money is any commodity that is generallyacceptedas a means of settling

payment

Money evolved into five different stages namely; commodity, metallic, coinage,

paper and representative money respectively

Money can move immovable property

Money must be scarce for it to perform its medium of exchange function

effectively

Economic systems use money to produce, allocate and distribute national

resources, above all money rules in a capitalist economy.

1.1.9 Suggestion for Further Reading

The student can read further on different kinds of money available to a modern economy

1.1.7 SelfTest Questions

Describe the challenges experienced during the commodity money

Why do you think that money is seen as a pivot on which the economic scienceclusters?

Explain why money is considered to be more important in a capitalist than a

socialist econom ?


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2.0 LECTURE TWO: DEMAND FOR MONEY SUPPLY OF MONEY

2.1 In troduction

Welcome to the second lecture of this unit. This chapter follows up on what we looked at

in the previous lecture. In the previous lecture, we saw that the core function of money is

its medium of exchange, money can be used as a store of wealth and a mode of settling

future transactions as mentioned earlier. If the above must be achieved, there is need to

have money. The demand for money is summarised below. Thereafter we will look at the

supply of money.

2.2 Lecture Outline

2.2.1 Demand for money

2.2.2 Determinants of transactional demand for money2.2.3 Keynesian approach to the demand for money

2.2.4 Supply of money

2.2.5 Components of money supply

2.2.6 Items excluded in the supply of money

2.2.7 Determinants of money supply

2.1.1 Specicific Objectives

At the end of this lecture the student should be able;

State briefly the demand for money

Explain the determinants of transactional demand for money

Give reasons why demand for money is insatiable

List components of money supply

Describe the determinants of money supply


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2.2.1 Demand for money

Introduction

Demand for money is basically different from the demand of commodities and services.

Demand for commodities is made because they have utility i.e. quality of satisfying the

needs of people. But money does not possess utility to satisfy consumers directly. Why is

money demanded?

Demand for money is made for two reasons;

1. It serves as a medium of exchange

2. It works as a store of value

As a medium of exchange, money help in the exchange of other goods and services and

acting as a store of value, it is held as an asset.

The former gives rise to the transaction demand for money while the latter gives rise to

the asset demand for money. The aggregate demand for money is the sum of these two

separate demands.

The supply of money or the volume of money in circulation refers to the volume of

money held by the public i.e. individuals PR business firms in the form of coins and

currency notes and deposits with the banks withdrawals by cheques. But it does not

include currency held by the central bank, the government and the commercial banks

The demand and supply of money determines the level of income, expenditure, savings,

investment, prices etc. in the economy.

Money problems of the economy are closely associated with and have remedies in

regulating the demand for supply of money.

2.2.2 Transactional Demand for money.

Demand for money is made to facilitate the trading activities i.e. purchases and sale

because in modern economy goods and services are purchased with some unit of

currency. it is therefore necessary for individuals and business firms to hold at least as

much money as required to meet their forthcoming expenditure. The cash balances held

by individuals and firms on hands for this purpose are called transaction balances

When the quantity of money held by all individuals and business firms is added up for the


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purpose of financing their forthcoming expenditure, then it is called transactional

expenditure

The need to hold money for transaction balances arises form the fact that the receipts and

payments do not occur simultaneously. They are never synchronized for both individuals

and firms, the fact is that the income is not wholly spent instantaneously but is kept to

meet the needs in future till the period, the income again is to be received ( the balance of

income will continue to smaller and smaller until it approaches zero or near zero by the

end of the month ) for business firms the receipts and payments will be spread over the

entire month. Thus the, it is luck of synchronization between money flows and money out

flows that compel them to hold money in cash for meeting day to day requirement. It

gives rise to transaction demand for money.

2.2.3 Determinantsfor transaction demand

1. Level of Income

The level of income determines the size of the transactions balances demanded. The

higher the level of income, the larger would be size of money holdings for transaction

purposes. The money holding for transaction purpose is the function of the level of

income.

MT = K.Y

Where MT =Money holding for transaction purpose

K=Proportion of level of income

Y=Level of national income

If the level of income (Y) is kshs. 1000, K is 1/5, the demand for transaction

purpose (MT) would be Kshs. 200

Or MT=1/5X1000

Or Kshs. 200If the national income changes, MT would change accordingly in the same proportion as

K is assumed ton be constant. If the National Income goes up to Kshs. 1500, the demand

for transaction purpose would be 1/5 Kshs. 1500i.e kshs. 300. The change in MT would

create or reduce the demand for money for transaction purpose in the economy.

2. Pattern of Income Payments and Expenditure


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The time lag between the receipt of income and payments is also important and influence

the demand for money. The larger the interval of income payments in an economy, the

larger the demand for carrying out transactions. An income of kshs. 1,200 yearly would

require on each per day kshs. 10,000 if paid yearly, Kshs. 1,000 if paid monthly and

Kshs.250 if paid weekly, hence larger money would be required if people spend their

income evenly over the income period than if they spend the income in a part of the

period of time.

3. System of payment

The system of income payments includes two factors;

a. Stages in transactions, and

b. Pattern of flow of payments

Stages in transactions

The system of payment also influences the volume of transactions and the demand for

money. Money passes through distinct stages viz. from income recipient to retailers and

then through a number of agencies to producers and again to recipients as factor

payments. The actual number which varies from economy to economy determines the

volume of transactions. The larger the number of stages in an economy, the greater the

volume of transactions and larger the demand for money.

Pattern of flow of paymentsIf the flow is regular and even, the smaller amount would be required for transactions.

Regular means payment from one stage to next stage is only when it is received from the

earlier one. If the flow is uneven or it is made even before payments are received from

earlier stage, the money requirement for transaction purpose would be greater.

4. Use of credit

This reduces the effective demand for money for transaction purposes. A given volume of

transaction would be possible to be carried out then. The use of credit postpones the

immediate requirement of money to pay of transactions. If credit is extended by a number

of parties to one another, it would be possible that a number of transactions would

council out and the final settlement may require a smaller amount the aggregate value of

all transactions. Thus credit economizes the use of money and wide prevalence of the

system reduces the demand for money.


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2.2.4 Keynesian Approach to the Demand for Money

One of the main functions of money is to serve as a store of value. The function gives

rise to the asset demand for money. The asset demand for money at a particular time

refer to the demand of individuals, business firms and the government for money to be

kept as cash balance as distinct from other assets. Money is an asset and is kept in the

form of cash balances. Being the most liquid asset it can serve as the store of value,

therefore it is demanded for its own sake and for purchasing goods and services to meet

out the needs of people. People want money to keep it in the form of cash balance

because, it has liquidity value.

2.2.5 Factors affecting asset demand for Money (Keynesian approach)

Money has the distinctive feature of being the only asset which is perfectly liquid.

Keeping it in the form of cash earns nothing.

Prof. Keynes has described three motives for holding money in the form of cash balances.

These are:

(a) the transactions motive

(b) the precautionary motive

(c) the speculative motive

(a)

The transactions motiveThe money needs for the current transactions by the

individuals and business firms because of its medium of exchange function.

Keynes determines this motive by the level of income

(b) Precautionary Motive or Demand The second motive for holding cash

balances by individuals, and business firms is to meet the requirements arising

out of any unforeseen or contingent incidents. Future is uncertain and

therefore individuals and business firms may need money for contingent

payments or expenditures mainly arising out of events of quite uncertain naturelike accidents, prolonged illness, or loss of job or replacement of a productive

asset destroyed or damaged by accident, etc. Any cash balances kept to meet such

contingencies, are known as precautionary balances. Such demand of money for

precautionary balances is also closely related to the level of income. The higher

the level of income, the more shall be the cash balances for contingencies.


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(c) Speculation DemandMoney also serves as a store of value which gives rise to

the asset demand of money. The speculative demand as referred to by Keynes is

the desire of the holder to keep cash balance as an alternative to the financial asset

like bonds. Keynes considered only two types of money cash and bonds.

People hold money in expectation of changes in interest rates or the capital value

of assets (bonds).

If people anticipate an increase in the prices of bonds, they would like to purchase bonds

at the current prices. If their anticipation proves correct i.e. the prices of bonds register

an increase, they will make capital gains of the transactions. Similarly, if they anticipate

a fall in the prices of bonds, they will prefer to sell them to avoid further losses. Thus

people convert their cash balances into bonds if prices of bonds are low and are expected

to rise and bonds into cash balance, if prices of bonds are high and are likely to fall.

Interest Rates and bond prices. A bond is a fixed-income bearing security which

brings in a fixed interest income on its face value. If bonds are purchased at par, the

income would be at the rate what has been ascribed on the face of it. As the bond

fluctuates in the market, the net income (yield) would be at a lower rate if bonds are

purchased at a higher market price (above par) or the yield would be higher, if they are

purchased at a lower market price (below par). Thus rate of interest and bond market

price has inverse relationship to each other.

If the bond prices are expected to fall, it would mean that the interest rates are expected to

go up. People would tend to sell their holdings with a hope to earn higher interest in

future. They will first convert their holdings into cash and keep that cash till the prices of

bonds actually fall. In that case, they are able to purchase more bonds with the same

amount of cash due to fall in prices and thus, in future, they will earn more interest and

vice versa

This is the most important canon of taxation. In the words of Adam Smith, Every

subject of a state ought to contribute with their respective abilities in proportion to the

revenue that they respectively enjoy under the protection of the state. It means that every

citizen of a country should pay taxes according to their ability but not necessarily in the

same amount. The rich person should pay more than the person with lower income. This

canon also implies equality of sacrifice i.e. the higher the income the greater the sacrifice


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one shall be called upon to make. This canon was put in the forefront of all other canons

with the view that all others have been derived from this one

2.2.6 Supply of Money

There are two views of supply of moneynarrow view and broader view. In the narrow

view of money supply or the volume of money in circulation, the money supply is

measured by the volume of money held by the public in a country in the form of currency

(notes and coins) and demand deposits (bank deposits transferable by cheques). It

includes only volume of money held by the public. Public here means individuals and

business firms operating in the economy but it does not include the Central Government,

the central bank and the commercial banks. Thus the money supply means the moneyheld by individuals and business firms. Money held by the Central Government in its

treasury, and lying with the central bank and commercial banks is not included in the

total supply. This is because of the two reasons:

(i) It is not in circulation, and

(ii) It might result in double counting because demand deposits form part of money

supply.

Thus, at a given point of time, total money in circulation is the total amount of money

supply that includes:

(i) Currency (notes and coins) and

(ii) Demand deposits of the public with the commercial banks.

This may be referred to as M1. It is the most widely accepted measure of money supply

for it includes only those assets which are generally acceptable as a means of payment.

Currency means legal tender money issued by the Government or the central bank. Its

general acceptability as a means of payment has made it an important constituent of

money supply. Likewise demands deposits held by commercial banks on behalf of the

public and can be withdrawn by cheques are also considered money as they are also

accepted as a means of payment. According to this view, time deposits and savings are

not money.

Broader View: A majority of economists prefer the narrow definition of money supply

that includes currency and demand deposits in money. But a group of economists


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strongly supports the store of value function of money. They point out that savings and

time deposits are close substitutes for currency and demand deposits and as such these

should also be included in the measure of money supply. They are of the view that time

deposits and savings frequently and easily changeable from time deposits to currency and

demand deposits and therefore they consider all bank deposits (time deposits and demand

deposits) in money supply, even though time-deposits cannot be used for making

payments. This measure of money supply is referred to as M2. Thus

M2= M1+ Savings and time deposits.

Or M2= Currency + Savings + Time deposits + demand deposits

Milton Friedman, the worlds foremost monetarist, believes that M2 is the correct and

best measure of money supply.

2.2.7 Items excluded from money supply

The following items are not included in the concept of money supply of a country:

(a) The stock of monetary gold kept in reserve by the central bank as a cover for

issuing paper currency is not included in money supply. It is so because, it is not

permitted to circulate within the country.

(b) The cash held by the commercial banks is also excluded from money supply as

they form the basis of deposit money of the public.

(c) The cash held by the Government in treasury and by the central bank of the

country is also not included in money supply as it constitutes the reserve on which

the demand deposits of the public are supported.

2.2.8 Components of Money Supply

The main components of money supply are:

1. Coins

2.

Paper currency and

3. Demand deposits

1. Coins

Coins mean metallic coin issued by the monetary authority of the country, the

central bank. There are two systems of coinage:

(a) Free coinage, and


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(b) Limited coinage.

i. Free coinage is a system under which everybody is free to get the coins

minted at the mint against the metal. Free mintage or coinage may be

gratuitous or non-gratuitous. Gratuitous coinage is that where government

does not charge anything for coinage whereas non-gratuitous mintage

means where the government charges for mintages.

ii. Limited coinage means where public is not authorized to get the coins

minted. The government mints on its own account. In other words, the

government enjoys monopoly over the minting of coins. Today, almost in

every country, the system of limited coinage is in vogue.

Coins were once the principal type of money in circulation, but now subsidiary

coins are in currency to facilitate transactions of smaller denominations. Now

metal used in coins is not important.

2. Paper Currency

Paper currency is the most important part of the monetary system today. The

government or/and the Central Bank of the country issue notes. Almost in every

country, the central bank enjoys the monopoly over note issue. The papercurrency in a country is regulated by the monetary system/policy laid down by the

monetary authority. Broadly speaking, three main systems of note-issue are

current:

(a) The fixed fiduciary system;

(b) The proportional reserve system; and

(c) The minimum reserve system.

(a) Under the fixed fiduciary system, the monetary authority is authorized to

issue notes up to a certain limit without having any metallic reserves.

Above that limit, 100 per cent metallic reserve is required to be

maintained.


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(b) Under the proportional reserve system, a fixed percentage of total note

issue is required to be kept in gold reserves and the remainder remains

uncovered. This system was adopted in India upto 1956.

(c) Under the minimum reserve system, a minimum amount is to be kept in

gold or silver reserves and then the monetary authority is permitted to

issue notes to any extent.

This currency is an important component of the money supply. The currency

componentcoins and notesis determined by the monetary authority according

to the monetary policy adopted by the central bank in consultation with the

Central Government.

In deciding the total volume of currency, the monetary authority is generally

guided by the economic requirements of the country. Some economic

considerations are volume of trade, nature of trade, price level in the country,

method of payment i.e., cash or credit instruments, amount of demand deposits,

bank habits of the public, distribution of national income, etc.

3. Demand Deposits

Now a deep, demand deposits have also occupied an important place in the totalmoney supply. Demand deposits are deposits of the public in commercial banks

where the bank is under an obligation to pay the amount to the extent of deposit

on demand to the depositor or to anybody else as directed by the depositor. Thus,

the people increasingly accept cheques for discharging their financial obligations.

This is the reason why demand deposits are treated as a part of money supply.

2.2.9 Determinants of Money Supply

Having discussed the components of money supply, we shall now turn to the

determinants of money supply. There are basically two determinants of money supply i.e

the monetary base (high powered money) and the money multiplier.

As we have already defined that M (money) is equal to the currency (C) including both

notes and coins, demand deposits of banks (DD) and other deposits in the nature of time

deposits (OD), all held by the public i.e.


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M = C + DD + OD

One of the determinants of money supply is High Powered Money(H). High Powered

Money is money by the central bank and the government and held by the public and the

commercial banks. It constitutes currency held by the public (C), cash reserves of banks

(R) and other deposits (OD), thus:

H = C + R + OD

The difference between M and H is that whereas the former includes demand deposits,

the latter includes reserves held by banks in place of demand deposits. We now present

very briefly a widely held theory of money supply known as high-powered money theoryor money multiplier theory.

The second important determinant of money supply is that money multiplier that

influences the quantum of money supply. The theory says that the supply of money (MS)

is a highly stable increasing fraction of high powered money (H). in other words, it

implies that:

(i) As H changes, M changes, in the same direction, and

(ii) That most of the change in M is due to the change in H.

Symbolically, the theory can be presented as such:

MS= mH

Here, Ms = Money Supply, m = money and multiplier and H = high powered money.

The equation deals with the determination of the total money supply, not just change in

the money supply. Now, we shall see how these two factors m and H are determined.

Money Multiplier Process. The money multiplier m is determined when the reserve

requirements on demand deposits (RD), reserve requirement of time deposit (RT),currency ration (C/D) and the time deposit ratio (T/D) is determined. With the variations

in these ratios, the money supply will also change. From the above equation, it follows

that m varies with these ratios and supply of money is positively related to the money

multiplier (m) or money supply varies in the direction of change in m.

We have observed earlier that:


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M = C + DD + OD, and

H = C + R + OD

Thus currency (C) and other deposits (OD) are directly a part of M and also of H. the

ratio between C and OD is decided by the public. The rest of H i.e. R stays with banks,

through their interaction with the public and the government it serves as the base for the

secondary creation of deposits. This results in multiply expansion of money, bank

deposits, and bank credits and constitutes the heart of the money multiplier process. The

process has been explained as follows:

Suppose, one rupee is injected in new H in the form of new demand deposits with banks.

This increases their reserves with full one rupee. The bank will keep a part of this rupee

in the form of reserves as per the requirement of the law and lends the rest. The recipient

will spend it in the market. Those who receive payments will retain a part of it and

deposit the balance with the banks, partly in the form of demand deposits and partly in

the form of time deposits. This causes a further increase in the time and demand

deposits. The return flow of a part of bank credit again induces the bank to lend the

balance keeping a part of fresh deposit as reserves in the second round. Their actual

reserves thus will be higher than the derived reserves. The process continues till banks

have retained their desired ratio and public its desired currency and time deposit ratios.

The process leads to multiple creations of bank credit, bank deposits and money. Henceit is called the money multiplier process and also the credit multiplier process. The

process thus, can be summarised as follows:

(a) The supply of money (MS) is positively related to m.

(b) The money multiplier (m) is inversely related to

(i) reserve requirement on demand-deposits (RD);

(ii) reserve requirement on time deposits (RT)

(iii) currency-deposit ratio (C/D)

(iv)

time deposit ratio (T/D)

Thus, the quantum of money is determined by high powered money (H) and money

multiplier (m).


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2.2.10 others determinants of money supply

The sources of changes in money supply are as follows:

i. Open market operations: Open market operations refer to the selling and buying

of the government securities on the open market by the central bank. A reduction

in money supply will occur if the government sell its securities through its brokers

since buyers will pay for these securities with cheques draw on their accounts

with the commercial banks. Conversely there is an expansion of money supply if

securities are bought on the open market by central bank and paid for by cheques

drawn upon the central bank. In this case, money supply will further be increased

if commercial banks undertake a multiple expansion of bank deposit.

ii.

Interest rate policy: since liberalisation of interest rate in 1991, the central bankinfluences the general level of interest rate by means other than the direct

prescription of the deposits and the 90-day. Treasury interest rate. Which

significantly affect the other rate of interest in the economy since commercial

banks constitute important buyer of this financial asset? An increase in this rate of

interest tends to reduce money supply and credit creations.

iii. Changing the cash reserve ratio: an increase in the cash reserve ratio reduces

the credit multiplier and hence reduces the money supply. A reduction in cash

reserve ratio is likely to increase the credit multiplier and hence increase money

supply.

iv. Special deposit: the central bank of Kenya has the power to require commercial

banks to lodge special deposit with it. Which compulsory they ensure a reduction

in commercial banks liquid asset and reduce the banks ability to increase credit

and hence the money supply.

v. Government expenditure financed by borrowing the central bank: if currency

issued by the government to finance its expenditure money supply will increase

and conversely a reduction in government borrowing from central bank will

reduce the rate of growth of money supply.

vi. Government borrowing from the banking system: if the public sector is

running a deficit it may want to borrow some funds from the banking system

which may lead to further expansion of money supply.


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vii. A change in the publics desired cash holding: a decision by the public to hold

more cash and small bank deposits will reduce money supply through its effect on

credit creation. If the public decides to hold less cash and bigger bank deposit,

money supply would be increase through a higher degree of credit creation.

viii. A change in banks demand for excess reserves: most models in the

determination of money supply assumes that banks will adhere to a constant ratio

of cash reserve to deposit on the assumption that banks will wish to expand

deposit to the maximum. In practice, however, banks could decide or be forced to

hold cash reserve in excess for legal requirements as happens in many developing

countries. This could happen if there are an insufficient number of credits worthy

borrowers. In this case, the bank cannot be sure of success if it uses open market

operation to increase money supply.

ix. Balance of payment disequilibrium: a balance of payments involves a net

outflow of foreign currency and the central bank has to finance the deficit by

providing foreign currency in exchange for domestic currency. Unless offset by

an expansionary open market operation, this will result in a reduction in the

money supply. Conversely, a balance of payment surplus involves net inflow of

currency and unless offset by a contractionary open market operation will result in

an expansion of the money supply.


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Discuss the Keynesian approach to the asset demand for money

Explain the determinants of Transactional demand for money

Define high powered money

2.2.13 SummaryIn summary, in this lecture we have learnt that;

Demand for money is made for two reasons; i) it serves as a medium of exchange, ii) it

works as a store of value Money

The stock of monetary gold, cash held by Commercial banks and Central bank are

excluded from the money supply

2.2.14 Suggestion for further readingRelated to this lecture, you can read further on;

Credit multiplier

Money supply in the Kenya

2.2.12 SelfTest Questions

Give reasons why demand deposits forms part of money supply

The demand for money is unique and insatiable discuss this statement fully

Highlight reasons why some items are excluded from the money supply

Explain the relationship between high-powered money and ordinary money

Write a note on the money multiplier


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3.0 LECTURE THREE: THEORY OF MONEY AND PRICE

3.1Introduction

Money is the life blood of the modern economies. We cannot think of an economy

without money. Money is used as a medium of exchange and it is its most important

function. .What a unit of money buys, in terms of commodities and services

represents its true value. But it is very difficult to measure the value of money, in

terms of each and every commodity. It is for this reason that the value of money is

expressed-in terms of general price level' which may also be called as the

purchasing power of money.

Just as theprice of a commodity. May increase or decrease, the general price, level

may also move upward or downward. The fluctuations in the general price level

have a great impact on the, value of money. General Price level and the value of

money are inversely related. 'If the price level goes up, it means the one unit. of

currency can now purchase less commodities and services i.e. the value of 'money

Or the exchange valueof money has decreased. On the contrary the fall in general

price level may increase the value of money. Thus, value of money means its

purchasing power in terms of commodities and services.' ' ,

Economists' have formulated a number of theories to explain the relationship

between the- supply of' money and the general price level.

3.2 Specific Objectives

By the end of this lecture the student should be able to;

Explain the Fishers quantity theory of money

Identify the equation of exchange

Highlight the assumptions of the theory

Criticize the theory


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3.3 Lecture Outline

3.3.1 Quantity theory of money - Fishers approach

3.3.2 The Transaction Approach

3.3.3 Equation of Exchange

3.3.4 Assumptions of Fishers Equation

3.3.5 Criticism of the Fishers equation

F ishers Quanti ty theory of money

3.3.1 Quantity Theory of money(FISHER'S APPROACH)

The Quantity Theory of money was first expounded by an-Italian economist Mr.

Davanzatti but the theory was popularizedbythe American economist, Irving Fisher who

gave it a quantitative form and explained by an equation known as Equation of Exchange.

At present, there are two versions-

i) The transaction approach, (transaction approach is associated with Irving Fisher)

(ii) The cash balance approach.

3.3.2TheQuantity Theory of Money The Transaction Approach

The value of money implies what a unit of money can buy in terms of' commodities

and services. The price of commodities or the general price level does not remain

constant hence the value of money 'also fluctuates. The two have inverse relationship. If

general price level increases, the value of money decreases or the value of money

'increases with the decrease in general price level.

The quantity theory of money indicates that the value of money in a given period

depends upon the quantity of money in circulation in the economy. The quantity' of

money supply determines the general price level and the value of money. Any change in

the money supply will change the general price level directly and the value of money

inversely inthe same proportion. e.g.if the quantity of money in circulation is doubled

other things being equal, the general price level will be doubled and the' value. Of

money is halved. Similarly, if the quantity of money is halved, the price level will be

halved and the value of money will be doubled. Prof. FW. Taussig has stated the


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tendency of this theory thus-

"Double the quantity of money, and other things being equal; prices will be twice as high

as before; and the value of money as, one-half. Halve the quantity of money, and other

things being equal; prices will be one half of what they were before and the value ofmoney double."

According to J.S. Mill,' "the value of money, other things being the same, varies

inversely as its quantity ; increase of quantity lowers the value and every diminution

raising it in a ratio, exactly equivalent

3.3.3 Equation of Exchange

The transaction version of the quantity theory of money was presented byIrving. Fisher

in the form of an equation known as equation of exchange as given below-

MV=PT

Where

M =Quantity of money in circulation

V = Velocity of circulation of money. It denotes average number of times a unit of

money changes hands.

P =Price level

T"=Total volume of transactions of goods and services during a' given period of time.

The above equation has two sides i e. MV and PT.

MV represents total supply of money in the economy

M represents the total money supply in circulation but a unit of money does not

purchase goods and services. in ' a given period of time, only once. It changes hands by a

number of times. Hence total money supply is represented by the 'quantity of money

multiplied by its velocity which is represented by MV in the equation:

PT, on the other side of the equation represents total demand for money or the money

value of all the goods and services brought during a given period of time. Hence total

volume of transactions (T)multiplied by theprice level (P) denotes the total demand of

money.

Thus MV=PT. or total supply of money (MV) is equal to total demand of money to


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purchase the total' transactions at a given price (PT).The equation is referred to as the

cash transaction equation. It could also be .expressed as follows- . '

P = MV

T

Thus, price level is determined by the total quantity of" money divided by the total

transactions. Thus the total quantity of money determines the price level provided P and,

T are constant.

The above equation was criticized by some of the monetary. experts on the ground that

the theory ignores completely the credit money and .its velocity both of which are.

important in the modern day economy. Irving Fisher, later, extended his original

equation, considering the credit money and its velocity represented by M' and" V'

respectively and put the extended equation as follows:-

MV+M'V'=PT

Or

P = MV + MV

T

The equation broadly indicates that the price level (P)is directly related to total quantity,

of money (original money and bankmoney) multiplied by its velocity. It, is, however,

inversely related to T. He has established in his equation the basic proposition that the

price level and the value of money is a function of money supply "providedother things.

remain constant. These other things are M'V. V and T and if they remain constant, price

level will change directly. And:proportionately with the change in money supply. Price

level affects the value of money inversely and thus changes in money supply influences

the value of money inversely.

Example 1;

(i) The following data relates to economy ABC:

M = 50 M1= 20 T = 450

V = 10 V1= 2


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Compute the countries:

(a) Price level

(b) Value of money

Solution

(a) P = 2450

900

450

20201050

xx

(b)2

11 P

Example 2;If money supply in a given economy equals 1000 while the velocity and price equals 16

and 4 respectively. Determine the level of nominal and real output.

Solution

P =T

MV

4 =T

x161000

T =4

161000x

T = 4,000Nominal output = 4,000

Monetary value of real output

P * Q = 4 * 4,000=16,000

3.3.4 Assumptions of Fishers Equation

(i) Price level (or P) is a passive' factor. P in the equation (Price level) is inactive' or

passive in the equation. Pis affectedby other factors in the equation i.e T, M, M' V or V'

but it does not influence-other factors in any way. p. is . Thus a resultant and not a cause.

(ii) T and V are constant. The theory assumes that T in the short period. Remains

constant because T depends upon the volume of production and the production

techniques do not change in the short period. Similarly, V depends upon the size of

population, state of economic development, money habits of the people, which remain


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unaffected during the short period." Hence T and V have been assumed constant in the

theory.

(iii) T and V are Independent Factors.Fisher assumes that total volume of trade (T)

and velocity of money (V) are independent variables in the equation and are not affected

by the change in any other factor. The volume of trade however, isdetermined by certain

outside factors. V (velocity of circulation at money) is also independent and was not

affected by change in M or P. .

(iv) The Ratio of Credit Money to Legal Tender 'Money Remains Constant. The

theory assumes that the ratio of credit money to legal tender money also remains constant.

If it is not constant the quantitative relation between' money and pricesas visualized in

the theory does not hold good. . .

Thus, four variables in the equation of exchange i.e., M' V, Vand T are assumed to be

constant during the short period. P is a passive factor, therefore, the change in the

quantity of money (M)directly affects-the price level (P)

3.3.5Criticismofthe Quantity Theory of money (Fishers equation of exchange)

. ,

(I) the theory is based upon; unreal assumptions. .According to Fisher P is a passive

factor, T is independent,' MV and V' are constant in the short period.Constant in the

short period. He covered 'up all these assumption under 'other things remaining the

.same'. But according to critics these other things do not remain '. Constant in "the actual

working of the economy hence they are-unrealistic and misleading. For example-

i. The velocity of circulation of money automatically changes with the change in

the quantity of legal tender money.

ii. there is no well-defined relationship between legal tender money (M) and

bank money (M/),

iii. Anychange in legal tender. Money will ~lso influence the velocity of credit

money (V').

iv. The assumption that T is an, independent factor and does not change, with -

the change in 'M. Which is not correct because T cannot remain constant


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consequent upon the change if} M. lf M increases. P will also, increase,

resulting in higher, profits which naturally' affect the production.

Impliedly, P cannot be assumed as a passive factor. It certainly influence T.

v. (v) Price level is not an outcome of changes in money supply. P also-

effectively influences the money supply. Thus, P also determines -M and M

determines P. Both are inter-' '

Thus, according to critics, the assumptions are not real because other things do not

remain constant. '

(2) A Long-Term Analysis of Money.The theory offers a long term analysis of value

of money and therefore, ignores the changes in short. Period. 'However, there are certain

violent- and far-reaching changes in the short run in the value of money which the

theory ignores.

(3) How Money-supply influences the price level is not Explained. The theory simply

presents: that the quantity of money affects the price level but it does not explain the

process how it is possible. MV=PT is simply a mathematical equation and 'explainsonly

that total supply of money is equal to total transaction-value. It throws: no' light on Cause

and effect relationship of money and price. '

(4) No, Direct and Proportional Relationship between' Quantity of Money and the

Price Level. The theory states that every Change in the money supply brings

proportional and direct change in the price level. But in actual life, no such relationship

exists because there are other external factors which disturb this relationship.

(5) Assumption of Full Employment is wrong. Keynes has raised an objection -

against the theory that the assumption of full employment is a rare phenomenon in a

economy and the theory IS not real. The relationship between M and P does not bold

'good if we assume unemployment in the economy. '

(6) The Theory is not comprehensive.According to Keynes, total legal tender money

arid credit, money does not constitute .the total sup-ply of money, because whole of it is

not used for the purchase of commodities and services. A part of the total legal tender

money is hoarded by the people which is not used for the ' exchange of goods and

services. So, the hoarded money should notbe considered,


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(7) Money Supplyis not the only factor influencing price level.

The change in price 'level is, not influenced merely by the change inmoney supply. There

are other factors such as change in national income, national expenditure, savings and

investments. According to, Prof. Crowther the value of money, in fact, is a consequence

of the total of incomes rather than of 'the quantity of money. It is the causes' of

fluctuations in the total of incomes of which we must go in search."

(8) The Theory Neglects Velocity of Commodities. The theory considers velocity of

money but ignores velocity, of circulation of commodities which is a serious drawback of

the theory.

3.3.6Other Criticism includes;a) Demand aspect of money is not considered.

b) The expression MV in the equation is not technically a consistent expression. M

refers to the quantity of money at a particular moment of time whereas V refers to the

velocity of circulation over a period of time. This is inconsistent.

c) It is not possible, according to critics, to measure the velocity of circulation of money.

d) According to critics, there, is time lag between the change in, money supply and its

effect on price level. It is not instantaneous' and immediate. It is slow and gradual. It

is possible that other things may not remain constant by that time.

(e) The theory also does, not consider the changes in the price ,level of other countries

which also affect the domestic price level without any change in money supply.' ,

The; above' criticism of the quantity theory of money assert that the theory is imaginary,

defective and' misleading. Keynes called it incomplete. The theory also lacks

mathematical exactness. But, it explains the tendency which. is Correct: hence the theory

occupies an important place in economics.


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1. If money supply in a given economy equals 4000 while the velocity and price equals 20

and 4 respectively. Determine the level of nominal and real output.

2. Comment on the following statements:

a) The quantity theory of money is a theory of demand for money

b) The quantity theory of money is a theory of Money-Income determination

3.3.7 Self-Test Questions

Supposing the politicians in country XYZ decide to increase money supply to

finance their campaigns by printing more coins and paper money, such that the new

M = 100 and M1= 40. Other factors remaining constant, compute the new:

(a) Price level

(b) Value of money

(c) Interpret your findings

Critically assess Fishers quantity theory of money

3.3.8 Summary

In summary, we have learnt the following;

The equation of exchange represents the two sides i.e the demand and the supply side

of money( MV-Supply, PT- Demand respectively)

Price is passive and do not affect other factors but a resultant of the factors,

Keynes equation represents the real cash balance equation,

3.3.9 Suggestionfor further reading.

Related to this lecture, you can read further on;

Monetarist view on the uantit theor of mone


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4.0 LECTURE FOUR: THEORY OF MONEY AND PRICES

CASH BALANCE APPROACH TO THE QUANTITY THEORY

4.1 Introduction

Fisher's approach' was "based on the medium of exchange function of money. It

emphasized the demand side of money. But ' a different approach tothe quantitytheory

of money has been attemptedby' the Cambridge economists,' like Marshall, Pigou,

Cannan, Robertson .and Keynes.This approach is known as Cash- Balance approach-

or the Cambridge Version of the quantify theory of money. This approach is based on

the 'store of value', function of money.The approach emphasizes the demand side of

money.

According to this approach, the value of money is determined on the basis of its demand

and supply. When the demand for money is equal to its supply, the valueof money, like

other things is settled. The changes in the value of money are thus caused by changes

either in its demand or in its supply or in both.In this way the approach isbased on the

general theory of value and is applicable to the problem of money. The approach

considers the demand for and supply of money at a particular point of time, rather than

over a period of time enunciated by the transaction approach.

According to cash balance approach, the supply of money is its stock at a particular

.time not its flowover aperiod of time and comprises all the cash and bankdeposits

subject towithdrawals by cheque.Demand for money, according to this approach, has

been interpreted in a different manner.

According to Fisher the demand for money is not for its own sake. 'It is made only to

purchase the commodities and services i.e. money is demandedbecause; it serves as a

medium of exchange.

But this theory emphasizes that the demand for money is made for meeting their day to

day requirements by individuals, firmsand governments, thus, the demand for. Money

refers to that quantity of money which the individuals, commercial firms and the

government hold to meet its day to day requirements. Thus the supply of money set

against the community's aggregate demand (or cash balances) determines the level


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of prices or the value "of money in the economy. If demand is constant, only change

in the supply 'of money will directly affect, the price level and inversely the money

value.

On the other hand, if supply is constant, the price level will change inversely and moneyvalue directly with any change in the demand for money. An increase in the demand for

money (for store purposes) will lower down the demand for goods and services because

peoplecan now have a larger cash balanceonly by cutting their expenditure on goods

and services consequently the price level will fall and the money value will go up.

Converse will be the case with the fall in demand for money.

4.3 Lecture outline

4.4.1 Introduction

4.4.2 Equations of cash balance approach

4.4.3 Similarities of Fishers Approach with the Cambridge Approach

4.4.4 Differences between Fishers and the Cambridge approach

4.4.5 Criticism of the Cash Balance Approach

4.4.2 Equations of cash balance approach.

(1)/ Marshall'sEquation-

Marshall's cash balance equation is

M=KY

Where, Mrepresents total supply of money

Kis that portion of income which they want to hold in the form of money.

4.2 Specific Objectives

By the end of this lecture the student should be able to;

Differentiate between cash balance approach and Fishers approach to the quantitytheory of money,

Understand the Cambridge/ Cash balance equations

Highlight the criticism of the theory


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1


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Where c represents cash in legal tender money, h represents theproportion of cash

reserves to deposits held by the bank.

(I-c)stands for the proportion of legal tender money which is kept in, the form of bank

deposits,

For explaining thechanges in the value of money, Pigou emphasized on Krather than

on M.

(3) Robertsons Equation

Prof. D.H. Robertson equation is somewhat different from that of Prof. Pigou. The

equation is-

M = PKT

P = M

KT

Or

Where, P = Price level

T=total amount, of goods arid. services to be bought during a year,

K= thatproportion of T which the people desire to hold in the form of cash.

(4) Keynes Equation

J.M Keynes, a noted Cambridge economist has presented his own equation known as

'The Real BalanceQuantity equation:

n = PK

or P = n

K

Where, n = total supply of money in circulation

P = Price of consumption goods

K = Total quantity of consumption units which the people went to held in cash.

Keynes refers to K as the real balance .

In the above equation, so long as K remains unaltered, theprice level will change

directly inproportion to change in n. . .

Keynes further

cfm 302. monetray theory policy

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