Chapter 02 MONEY & BANKINGInstructor: Ms. SHAHZEEN SHAH
The Value of Money is the Purchasing Power. The real value of a unit of money at a given time and place is the quantity of goods and services of all kinds that can be purchased with a unit of money. The value of money varies inversely with the general price level.
Cash Transaction approach to the Quantity theory of money was given by Irving Fisher (American Economist) in his book ‘The Purchasing Power of Money’ (1911). The value of money (The purchasing power) in a given period of time depends upon the quantity of money in circulation (Money Supply). Money Supply determines: the General Price Level
Quantity theory of money is the theory that suggests money supply has a direct, proportional relationship with the price level and an inverse relationship with the value of money (Purchasing Power). In Fisher’s words, ‚Other things remaining unchanged, as the quantity of money in circulation increases, the price level also increases in direct proportion and the value of money decreases and vice versa‛. For example, if the quantity of money in circulation is doubled other things being equal the general price level will be
Supply of Money• Quantity of Money (M.S.) in circulation ‘M’• Velocity of Money in circulation ‘V’• MV= the total volume of money in circulation during a period of time. Demand for Money• The Demand for money is for the exchange of goods.
P = MV + M1 V1 or PT= MV+ M1V1 T Here, P is the price Level M is the quantity of money V is the velocity of circulation of M M1 is the volume of credit money V1 is the velocity of circulation of M1 T is the total volume of goods and Trade
Economists frequently debate how changes in theamount of money that circulates in a nations economy(the money supply) influence the prices of goods andservices exchanged in that economy (the price level) aswell as the total quantity of goods and services producedin that economy, or the output. The quantity theory ofmoney (QTM) and the Cambridge cash-balance theoryare two of the most prominent approaches tounderstanding this complicated subject.
QTM, transaction approach, argues that changes in themoney supply directly influence the price level. As themoney supply increases, the value of each dollar (orwhichever kind of currency a nation uses) declines, andtherefore it takes correspondingly more dollars to buyany given good or service. Consequently, an increase inthe money supply will cause prices to rise. Implicit in thisassertion is that money is only valued to meet peoplesdemand to conduct transactions -- for example, peopleuse money merely to meet their "transactions demand."
The cash-balance theory adopts a more nuanced understanding of peoples psychological relationship with money. It assumes that money serves important purposes in an economy other than meeting the transactions demand.First, people do not sell and buy items simultaneously. Instead, they hold on to cash as a "store of value," acquiring money one day to spend it another day.Second, people frequently retain money just in case they might need it in an emergency. This means that people also have a "precautionary" motive to hold on to money.The cash-balance theory, therefore, rejects the notion that a smooth relationship necessarily exists between money and prices, with people automatically spending more money as the supply increases. Moreover, fluctuations in the demand for money might actually influence output and, hence, the economys real size.
Both QTM cash transaction and the cash-balance theoryaccept that, in the long run, the money supply and pricelevel rise and fall together without changing output.Unlike QTM cash transaction, however, the cash-balance theory asserts that people often have strongmotivations to hold on to money. Hence, according to thecash-balance theory, the money supply and price level --and perhaps even output -- may diverge in the short run.