The Quantity Theory of Money

-Explain the concept of money, it’s functions and characteristics.

-Explain the theoretical link between money and prices.

-Explain the Quantity Theory of Money.

Medium of exchange: replacement for barter (used to purchase item instead of exchanging for another i.e. barter)

Standard of value: we use money to compare the values of commodities.

Store of value: for the purpose of saving (as long as we are confident that it will keep/store it’s present value and therefore retain it’s purchasing power in the future when we come to use it)

Means of deferred payment: being able to borrow money and pay it back over a relatively long period of time.

Functions of Money

1. Portability: can be carried around easily (in wallet or pocket)

2. Durability: must be able to stand the test of time without disintegrating

3. Divisibility: be able to divide into smaller units to enable a wide range of transactions e.g. $1 = 100cents.

4. Recognisability: not easily copied (forged)

Six Qualities (characteristics) of Money

Recongnisiblity

5. Acceptability: the legal status of money is given as legal tender by government

6. Relative scarcity: an increase in the money supply can lead to a fall in it’s value. People need to be confident that the value of their money will be maintained by for example the government (via controlling the amount of money circulating in the economy)

Qualities (characteristics) of Money

RBNZ ( Reserve Bank of NZ) – Established in 1934 and is given the sole right to issue notes and coins.

M1 = notes and coins held by public plus transaction account balances held at banks.

M2= M1 + on call funds at registered banks. E.g. Savings accounts (usually have to go to the bank to acquire these funds)

M3 = M2 + term deposits at banks and other financial institutions.

Money Supply

An economic model used to show the link between the amount of money circulating in an economy and price (inflation)

The quantity theory of money

Example

Income

Spending on Goods and services

We are imagining that the money stock = 100 (M)So workers must have been paid $100 (Income)The goods that they bought were also worth $100 (Spending) – Four crates ($25 each)Money has circulated ONCE in the year. From firms to households then from households to firms.

So Money stock = Price of each good x quantity of goods (Q)M = Q

Assume the economy only has households and producers

There are only four crates of goods produced in this economy

Example two Money will circulate more than once a year.

Imagine money circulates four times in a year.

Each time the firm pays the households $100 for their labour and households buy four crates from firms. (Total 16 crates)

So

Money stock (M) x the number of times the money circulates (v) = Price of each good (p) x the number of goods Q

100 x 4 = 25 x 16

MV = PQ M = the money stock V = the velocity/speed of circulation (the

number of times a unit of currency e.g. $10 note is used in a given period of time to buy G&S’s)

P = the general price level Q = total output (GDP)

The Quantity Theory of Money

Suggests that both V (speed of circulation) and Q (output of goods and services) are constant.

Therefore M (the money stock) is proportional to P (general price level). Which implies that the general price level will rise with

an increase in the money stock, and fall with a decrease in the money stock.

MV=PQ

The Crude Quantity Theory of Money

- most common theory

If the money supply is increased by 15% (remembering level of GDP assumed to be fixed), this will mean that there is MORE money in circulation chasing the same quantity of goods. This in turn bids up prices as the purchasing power of each dollar falls.

The end result will be a proportional increase in the price level, i.e. 15% increase in P.

Example of Crude QTOM

M V = P Q

Increases Increases by 15% by 15%

Quantity Constant?

It is clear, real output, can change over time. This means that the assumption that Q is constant is a weakness – This leads us to the Sophisticated Quantity Theory of Money.

Assumes only V (velocity of circulation) is constant, as the output of goods and services produced can change.

Therefore if the money stock was to increase, this could lead to either a rise in the general price level (P) OR an increase in output (Q). If the economy is operating near full capacity

there will be very little room for Q to increase, therefore the P (general price level) will rise.

If the economy is operating under full capacity it has the potential to utilise idle resources to off-set inflation (rise in P).

The Sophisticated Quantity Theory of Money

Work Book page 15 – 1619-20

PEAK/BOOM

TROUGH/Recession

Economic activity

% Change in RGDP

Time

Upt

urn/

reco

very

Dow

nturn

PEAK/BOOM

TROUGH/Recession

Dow

nturn

Downturn

Upt

urn/

reco

very

Upt

urn/

reco

very

THE BUSINESS CYCLE

Peak / upswing – High Economic Activity Low unemployment High Investment Consumer and business confidence is high. High Inflationary Pressure

Downturn/Recession Reduced economic activity High Unemployment Reduced investment Unemployment increasing Consumer and business confidence is low Disinflation or deflation occurring

The Business Cycle

When an economy is operating near its full capacity, all resources and technology are being fully utilised and output is unlikely to be able to increase to help offset the increase in money stock. The economy lacks spare resources required to produce the extra output. So real output cannot increase when money stock is increased. This means the price level (inflation) will increase. Economic

activity

Time

Near full Capacity

If the economy is not near full utilisation, the there are resources available to be used to produce more output. If the economy is not near full capacity then there are resources ( Capital and Labour) available to be used to produce more output. It is possible for an increase in the money stock to be absorbed by increases in output, meaning inflation is less likely to occur. Economic

activity

Time

Not near full capacity

Recession = When Real GDP falls for two successive quarters

Depression = a very severe recession

Work book page 43-44