Theories of Money
The quantity theory of money
postulates a direct and immediate link between the money supply and aggregate
demand, by assuming that households and firms only hold money for the purpose
of financing their transactions. An increase in the money supply will result in
a situation where households and businesses have more money than they wish to
hold in transactions balances and they will spend the excess, thus resulting in
an increase in aggregade demand. Restriction of the money supply will result in
a situation where households and businesses have less money than they wish to
hold, so they will reduce expenditures in order to increase their money
balance, thus reducing aggregate demand.
The Keynesian theory, on the
other hand, suggests that the changes in the demand for and supply of money are
reflected immediately only in the market for securities. Keynesian theory holds
that if households and businesses have excess money they will invest it in
securities, and if they have too little money they will sell some of their held
securities. Changes in money supply will not be reflected immediately in
aggregate demand, although the effect on the securities market will have an
indirect effect on aggregate demand through the interest rate.
In some circumstances,
monetary policy may be unable to raise aggregate demand, even indirectly. If,
in business managers’ opinions, investment opportunities are poor, perhaps
because the level of economic activity is low and general business expectations
are pessimistic, then an expansionary monetary policy may be ineffective.
Commercial banks may have difficulty persuading businesses to take on new
loans, and businesses managers may decide not to invest in new ventures even
though their expected return is higher than the prevailing interest rate. In
these circumstances, the demand to hold money may be strong, so expansion of
the money supply winds up largely in idle money balances, rather than being
spent on the purchase of bonds. Since the securities market is unaffected, the
interest rate will not change; so even the indirect effect on aggregate demand
is neutralized.
The Quantity Theory of Money
The naïve form of the quantity theory proposes a
direct relationship between changes in the money supply and changes in the
general price level. This can be stated as MV=PT where M is the quantity of
money in circulation (the money supply), V is the velocity of circulation—the
average number of times each unit of money is spent per period, P is the
general level of prices, and T is the total number of transactions in the
period. MV is referred to as the monetary side of the equation and PT is referred
to as the commodity side. On the monetary side, the amount of money in
circulation times the number of circulations per period must equal the total
value of all transactions in the period. On the commodity side, the average
price of all goods times the number of transactions per period must also equal
the total value of all transactions in the period. The two sides are thus by
definition equal.
Naïve quantity theory
supposes that the velocity of circulation is comparatively stable over time,
depending on habit, institutional arrangements, the manner in which wages are
paid, etc. and could therefore be regarded as constant in the short run. The
number of transactions would very directly with the level of real income: T=Y.
No multiplier constant is needed because the units of price level are
unspecified. So, MV=PY. Furthermore, naïve monetarists believe that market
forces will always force Y equal to the full employment level, by which view Y
can also be considered constant in the short term. So, with constant V and
constant Y, M=P. Thus the conclusion of the naïve quantity theory is that
changes in the money supply affect only the price level and nothing else. As a
result, monetary policy cannot have any effect on real output or income.
The naïve quantity theory can
be modified to yield the ‘modern’ quantity theory, which suggests that changes
in the supply of money can affect real income and output, with the magnitude of
the effect varying inversely with how close the economy is to full employment.
If substantial unemployment exists, Y is well below Q. Under these
circumstances, if the supply of money increases then households and businesses
will spend the excess above the amount they wish to hold for transactions
purposes. The additional demand created would lead to an increase in income and
output (Y) and therefore employment. As the economy approaches full employment,
however, further increases in the money supply will begin to affect the price
level more than the level of income. Finally, when full employment is reached,
increasing the money supply can only affect the price level since employment
can no longer increase. The modern quantity theory therefore attempts to show
that so long as unemployment exists, changes in the money supply will have a direct
effect on aggregate demand, with the magnitude of the effect depending on the
size of the gap between current employment and full employment.
The Keynesian Theory of Money
Where the quantity theory
treats money exclusively as a medium of exchange, they Keynesian theory
stresses that money serves other functions as well. There are three types of
demand for money balances:
·
The transactions demand, which arises
from the fact that people need money to finance current transactions.
Households and firms hold money balances to bridge the gap between the reciept
of income and its expenditure. The amount of money held for such purposes will
be closely related to the level of national income. However, it is also likely
to be influenced by the rate of interest. If the rate of interest is high,
there will be a strong motive to avoid holding money and instead hold interest
bearing assets.
·
The precautionary demand, which consists of money to be held to meet the
sudden arrival of unforseen circumstances. Again, the main factor likely to
influence this amount is the level of income, though again high interest rates
will tend to push money out of this category.
·
The speculative demand, which emphasizes the use of money as a store of
wealth rather than a medium of exchange. Holding money has an opportunity cost:
The income or utility foregone on the investments or goods the money could have
bought. Therefore it would seem that households and firms ought immediately to
invest or spend all money above that required for transactional and
precautionary needs. However, in the presence of uncertainty, individuals or
firms will sometimes believe that the returns available in the future might be
sufficiently better than the returns available today that it is worth waiting.
The speculative demand bears
further analysis. While there will be speculation on all goods and services
whose price can change with time, the speculative demand is particularly
interesting in the market for government bonds. If households and firms believe
the price of bonds will fall in the near future, they will be likely to sell
their current holdings of bonds and to defer purchasing new bonds until the
price drop has taken place. These actions increase the supply and reduce the
demand for bonds on the open market, which will have the effect of lowering
their price. Under this situation, the speculative demand for money will be
high as households and firms will wish to hold money in anticipation of the
price drop. Conversely, if households and firms expect bond prices to rise,
then they will defer selling bonds now and, if they have money available, will
tend to want to buy bonds. This will decrease the supply and increase the
demand for bonds, driving prices up; and the speculative demand for money will
be low, because speculative monies will tend to be invested in bonds.
The price of government bonds
and the interest rate are inversely and tightly related. Suppose that an
individual is considering the purchase of a government bond which pays $10 per
annum. The bond will not be worth buying unless it returns at least the current
rate of interest. If the current rate of interest is 10%, then the bond is
worth buying only if it costs $100 or less. If the current rate of interest is
15%, then the bond is only worth buying at $66.67 because this is the amount
over which $10/year represents a 15% return. In a competitive market, sellers
will not be willing to sell at less than the ‘going rate’ so bond prices will
be very closely pegged to the price at which they provide a return equal to the
currently prevailing rate of interest. (Or: The interest rate is the return on government bonds; the
more you have to pay for them, the less return you’re getting.)
We have established that the
speculative demand for money varies based on the expected changes in bond
prices. If bond prices are expected to fall, the demand will be high, and vice
versa. Since bond prices vary inversely with the interest rate, if the interest
rate is expected to rise, the speculative demand for money will be high, and
vice versa. It is reasonable to suppose that when the interest rate is quite
low, most people will expect it to rise; and when it is quite high, most people
will expect it to fall. Therefore, the speculative demand for money varies inversely
with the currently prevailing interest rate. If the interest rate is low, then
the expectation will be that it will rise, which means that bond prices will
fall, which means people would rather hold onto their money so they can buy the
cheap bonds later, so the speculative demand for money will be high; and vice
versa through the whole process.
Considering all three types
of demand for money, it follows that the overall demand for money balances will
vary directly with the level of income and inversely with the rate of interest.
Higher (lower) Y means more (less) money held in transactional and
precautionary balances. Higher (lower) interest rates mean more (less)
incentive to reduce money balances so as to take advantage of investment
returns, and also more (less) incentive to purchase government bonds with money
otherwise held in speculative balances. For a given Y, the relationship between
the demand for money and the rate of interest is called the ‘liquidity
preference schedule’ which looks like this:
The point on the demand curve
that intersects with the (vertical) money supply curve will determine the
equilibrium rate of interest. MT+P represents the amount of money
held for transactional and precautionary purposes, which for our purposes is
assumed to vary only with Y. Since Y is held constant here, MT+P is
a vertical line: At all rates of interest, the same amount of money is held.
The speculative demand for money is a function of the rate of interest,
reflected in the sloped portion of the demand curve. However, once a
sufficiently low interest rate is reached, the curve becomes horizontal. This
reflects the observation that at very low interest rates, households and firms
are simply not interested in buying any more bonds. For one thing, the interest
rate is so low that everyone is convinced it should rise soon, so nobody will
want to invest in current, low-yield bonds. Once this point has been reached,
further increases in the money supply will simply find their way to idle
balances and further reductions in the interest rate will not occur.
The Keynesian theory of
money, unlike the quntity theory, suggests that changes in the money supply do
not lead directly to changes in aggregate demand. Instead, monetary policy
affects interest rates, thus indirectly influencing those components of
aggregate demand which are sensitive to interest rates. Note that we can
conclude from this that the graph above is inadequate to explain the final
equilibrium interest rate. The graph above is for a fixed value of Y. But a
change in interest rates (at least along the sloped portion of the curve) will
result in a change in Y. So the initial equilibrium shown by the graph above
cannot be the final value. This will be analyzed in detail later.
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