money and banking

1. Module: Money and Banking
Topic: Monetary Theories.
Week 7
Mr. Aamir waheed
Department of Commerce

2. Lecturer Objectives
This lecturer aims:
 To Understand the concept of Value of
Money
 To Understand the Quantity Theory of
Money; Fishers Approach
 To Discuss the Assumptions of Fishers
Approach
 To Discuss the Criticism of Fishers Approach
Ch 1 -2

3. Value of Money
By value of money is meant its purchasing
power—its capacity to command goods in
exercise for itself.
It depends on the prevalent price level. If the
prices are high, the value of money will be
low. Conversely, if the prices are low, money
will buy more and the value of money will be
high.
Ch 1 -3

4. The value of money is inversely proportional
to the price level or we can say that the
value of money is the reciprocal of the price
level.
Ch 1 -4

5. Quantity Theory Of Money;
Fisher Transaction Approach
Ch 1 -5

6. Irving Fisher an American economist put
forward the Cash Transaction Approach to
the quantity theory of money. He in his book
The Purchasing Power of Money (1911) has
stated that the value of money in a given
period of time depends upon the quantity of
money in circulation in the economy. It is the
quantity of money which determines the
general price level and the value of money.
Ch 1 -6

7. 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.
Ch 1 -7

8. For example, 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
doubled.
Ch 1 -8

9. In Fisher‘s Cash Transactions Version of
Money, the general price level in a country,
like the prices of commodities, is determined
by the supply of and demand for money.
Ch 1 -9

10. (a) Supply of Money:
The supply of money consists of the quantity
of money in circulation (M) and the velocity
of its circulation (V) i.e., the number of times
the money changes hands. Thus MV refers
to the total volume of money in circulation
during a period of time. For example, if the
total money supply in Pakistan Rs. 5,000
billion and its velocity per unit of time is 10
times, then the total money supply would be
Rs.5,000 x 10 = Rs.50000 billion.
Ch 1 -10

11. (b) Demand for Money:
People demand money not for its own sake.
They demand money because it serves a
medium of exchange. It is used to carry every
day transactions. In short, the demand for
money is for the exchange of goods.
Ch 1 -11

12. Equation of Exchange
PT= MV+ M1V1
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
Ch 1 -12

13. Assumptions of the theory
1) Full employment: The theory is based on the
assumption of full employment in the economy.
2) T and V are constant: The theory assumes that
volume of trade (T) in the short run remains
constant. So is the case with velocity of money (V)
which remains unaffected
Ch 1 -13

14. (3) Constant relation between M and M1.
Fisher assumes constant relation between
currency money M and credit money (M1).
(4) Price level (P) is a passive factor. The price
level (P) is inactive or passive in the equation.
P is affected by other factors in equation i.e.,
T, M, M1, V and V1 but it does not affect them.
Ch 1 -14

15. Relationship between Quantity
of Money and Price Level
Figure shows equi-
proportionate changes
between M and P. As
quantity of money
increases from M0 to
M1, price level rises
from P0 to P1 and
making the changes in
the quantity of money
equal to the changes
in the price level.
Ch 1 -15

16. Criticism of the theory
(1) Unrealistic assumptions: The theory is
based on unrealistic assumptions. In this theory
P is considered as a passive factor. T is
independent. M1, V, V1, are constant in the
short run. All these assumptions are covered
under ―Other things remaining the same. In
actual working of the economy, these do not
remain constant; hence, the theory is
unrealized and misleading.
Ch 1 -16

17. (2) Various Variables in the transaction are
not independent. The fact is that they very
much influence each other. For example
when money supply (M) increases the
velocity of money (V) also goes up Take an
other case. Fisher assumes (P) is a passive
factor and has no effect on trade (T). In
actual practice, when price level (P) rises, it
increases profits and promotes trade (T).
Ch 1 -17

18. (3) Assumption of full employment is wrong.
J. M. Keynes has raised en objection that
the assumption of full employment is a rare
phenomenon in the economy and the theory
is not real.
Ch 1 -18

19. (4) Rate of interest ignored. In the quantity
theory of Fishers, the influence of the rate of
interest on the money supply and the level
of prices have been completely ignored. The
fact is that an increase or decrease in
money supply has an important bearing on
the rate of interest. An increase in money
supply leads to a decline in the rate of
interest and vice versa.
Ch 1 -19

20. (5) Fails to explain trade cycles.
The theory fails to explain the trade cycles. It does
not tell as to why during depression, the increase
in money supply has little impact on the price level,
Similarly, in boom period the reduction in money
supply or tight money policy may not bring down
the price level. G. Crowther is right in saying,
―The quantity theory is at best an imperfect guide
to the cause of the business cycle.
Ch 1 -20

21. (6) Ignores other factors of price level.
There are many determinants other than M,
V, and T which have important implication
on the price level. These factors such as
income, expenditure, saving, investment,
population consumption etc have been
ignored from the purview of the theory.
Ch 1 -21

22. Ch 1 -22

23.  Cambridge cash balance theory of demand
for money was given by Cambridge
economists, Marshall and Pigou.
 emphasis on the function of money as a store
of value instead of Fisher’s emphasis on the
use of money as a medium of exchange.
Ch 1 -23

24.  The exchange function of money solves the
problem of double coincidence of wants
faced in the barter system. While the function
of money as a store of value lays stress on
holding money as a general purchasing
power by individuals over a period of time for
the sale and purchase of goods or services
and subsequent transactions in the future.
Ch 1 -24

25. Demand For Money
 According to fisher, demand for money is to
serve as a medium of exchange
 in Cambridge model, demand for money
implies the demand for cash balance.
 People desire to keep certain portion of the
income in cash balance for transaction and
precaution motives.
Ch 1 -25

26. Ch 1 -26

27. Criticism of Cash Balance Approach
Use of purchasing power for consumption goods
 Give undue importance to the purchasing power of
money in term of consumption of goods
 They ignore the speculative motive of demand for
money
Role of Rate of Interest ignored
 They ignore the rate of interest in explaining the
changes in price level which is very important in
influencing the demand for money
Ch 1 -27

28. No explanation of business cycle
 They ignore the fluctuations in a nation's
aggregate output and employment over
time. Business cycle shows the different
phases an economy experiences over the
long-run: expansion, peak and recession.
Ch 1 -28

29. Many Thanks
Ch 1 -29