Theories of Money: Applied Economics, Study notes of Applied Economics

Download Theories of Money: Applied Economics and more Study notes Applied Economics in PDF only on Docsity! Applied Economics Theories of Money (With Approaches) Value of money is a term that is necessary to be understood to get acquainted with the theories of money. Some of the economists explained value of money as the value of gold and silver in terms of their weight and fineness. Other has defined the value of money as the value of Indian currency against foreign currencies. On the other hand, few economists have associated the term value of money with the internal purchasing power of a nation. Logically, value of money is associated with its purchasing power - the quantity of goods and services that can be purchased with a unit of money. Take note: Values of money and price levels in a country are inversely proportional to each other. Ex: When the price level in a country is high, the value of money is low and vice-versa. Three main approaches used for the monetary analysis of a country a. Quantity Velocity Approach/Cash Transaction Approach/Freidman’s Restatement - the changes in price level of a country occur due to changes in the quantity of money in circulation, while keeping other factors at constant. In other words, an increase or decrease in the price level would occur due to increase or decrease in the quantity of money. - price level and quantity of money are directly proportional to each other - in extreme conditions, an increase in the quantity of money would lead to a proportional decrease in the value of money, while keeping other factors at constant and vice versa. - The quantity theory is criticized on a large scale due to its static nature. In quantity theory, most of the factors remain constant, which is not true as real world conditions are dynamic in nature. Therefore, all the factors in this dynamic world keep on changing with time. - The quantity theory has not explained the process by which the change in quantity of money produces change in the price level. - This theory also considers that money is only used for the transaction purposes. However, it can also be held by individuals as idle cash and savings. In the quantity theory, the other factors that are kept constant are as follows: (a) Velocity of circulation of money: - Refers to the frequency at which a single money unit flows from one individual to another. For example, if a ten-rupee note circulates through 10 individuals, then the quantity of money would be 100, but not 10. (b) Credit instruments: - Help in increasing the quantity of money. An increase in the use of credit instruments, such as bank cheques and book credit, would lead to an increase in the quantity of money. (c) Barter system: - Involves transactions that take place without the use of money. Such transactions are either discarded or considered to increase the quantity of money. (d) Volume of transactions: - Requires to be constant. Volume of transactions refers not only to the amount of goods and services exchanged, but the number of times money changes hand. Prof. Irvin Fisher has provided a formula for explaining the relationship between quantity of money and its value, which is as follows: P = MV + M’V’/T Where, P = Price level/Value of money M = Metallic money M’ = Credit money V = Velocity of metallic money V = Velocity of credit money T = Transactions performed by money In the preceding formula, the supply and demand of money becomes equal. When the price level is multiplied by the transactions performed by money, it provides the total value of transactions (PT) also called as the demand for money. PT is equal to the supply of money as it includes cash and credit instruments along with their velocities (MV + M’V’), which is described as follows: PT= MV + M’V’ MV + M’V’/T According to Fisher, the values of T, V, and V remain constant. In addition, the proportional change between M’ and M also remains constant. Therefore, P and M are directly proportional to each other. In other words, the value of money (I/P) is inversely proportional to quantity of money (M). Prof. Fisher has explained that in short run, there are no or negligible changes in the economic factors, such as population, consumption, production, production techniques, technology, customer’s tastes and preferences, and circulation of money. Therefore, the demand for money is constant in short run. With respect to the supply of money, the circulation of money and credit is dependent on the habit of people. The proportional change between M’ and M depends on bank policies. Therefore, these factors also remain constant in short-run. Apart from the quantity of money, other factors may also produce changes in level of price and consequently in the value of money. Such as population, frequency of transactions, and velocity of circulation. Other factors, such as M, V, M’, and V’, are not independent factors. Among these factors, one factor can easily bring changes in other factors. For example, change in M can produce changes in V, which further make changes in the value of P. b. Cash Balances Approach/Cambridge Equation: - The modification of quantity velocity approach and is widely accepted in Europe. - This approach is based on national income approach and considers the concept of liquidity. - The value of money depends on the demand and supply of cash balances for a given period of time.