Money Supply | Demand for Money | Quantity Theory of Money | Criticisms of the Quantity Theory of Money
Money Supply | Meaning of Money Suply
Money supply indicates the stock of total currencies in a country’s economy.
It also includes all other liquid instruments related to money.
It is measured for a particular period of the fiscal year.
The governments issue paper currency and coin through central banks and treasuries.
Bank regulators influence the money supply available to the public through the requirements.
Money supplies impact the price level.
Here, price level refers to the price or cost of a good, service or security in the economy.
Money is the primary source to settle day-to-day financial transactions.
Cash and coins are the most liquid forms of money.
They can be used instantly and universally to settle unlimited transactions.
Demand deposits (accounts with banks) are also quite liquid.
They can be used by writing cheques for the settlement of daily transactions.
In Nepal, two types of money supply are in use; they are narrow money (M1) and broad money (M2).
Narrow money (M1)
The sum of currency in circulation and demand deposit at banks is called narrow money (M1).
Narrow money or currencies include paper money and coins.
It includes demand deposits and all types of money deposited at the bank.
It also includes other deposits held at the central bank.
The formula of narrow money
M1 = C + (D) + OD
Where:
M1 = Narrow money
C = Currency held by the public
DD = Demand deposits held by the public at banks and
OD = Deposits of central bank
Broad money (M2)
The broad money supply refers to all types of narrow money plus time deposit.
The time deposits consist of saving deposits, fixed deposits, call deposits and margin deposits.
The formula of narrow money
M2 = M1 + TD
Where:
M2 = Broad money
M1 = Narrow money
TD = Time Deposits
###########
|
Click on the link for YouTube videos: |
|
|
Accounting Equation |
|
|
Basic Journal Entries in Nepali |
|
|
Basic Journal Entries |
|
|
Journal Entry and Ledger |
|
|
Ledger |
|
|
Subsidiary Book |
|
|
Cash Book |
|
|
Trial Balance & Adjusted Trial Balance |
|
|
Bank Reconciliation Statement (BRS) |
|
|
Depreciation |
|
|
Final Accounts: Class 11 |
|
|
Adjustment in Final Accounts |
|
|
Capital and Revenue |
|
|
Single Entry System |
|
|
Non-Trading Concern |
|
|
Government Accounting |
|
|
Goswara Voucher (Journal Voucher) |
|
###########
Quantity Theory of Money | Fisher’s Equation
The quantity theory of money states that the determinant of the quantity of money is based on the price level.
Any change in the quantity of money produces an exactly proportionate change in the price level.
If the quantity of money is doubled, the price level will also double and the value of money will be one half.
On the other hand, if the quantity of money is reduced by one half, the price level will also be reduced by one half and the value of money will be twice.
According to Fisher, “Other things being equal, 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.”
To explain this theory, Fisher developed the equation of exchange, which is expressed as PT = MV
This equation of exchange shows the equality between the demand for money and the supply of money.
Demand for money (PT) = Supply of money (MV)
Further extended the equation of exchange expressed as:
PT = MV + M1V1
Or, P = (MV + M1V1) ÷ T
Where:
P = Price level
T = Total volume of trade
M = Total volume of legal tender money
M1 = Total volume of bank Money
V = Velocity of circulation of the legal tender money
V1 = Velocity of circulation of bank money
Thus, according to this equation, there are four determinants of price level and value of money.
1. The value of money is determined by the interaction between demand and supply of money.
2. Price level varies positively and proportionately with the money supply.
3. Value of money varies inversely and proportionately with the money supply.
4. Money acts only as a medium of exchange.
Click on the photo for FREE eBooks
ACCOUNTING, ECONOMICS, BUSINESS STUDIES, FINANCE, ENGLISH eBooks, EP Online Study
Demand for Money
When the populations want to hold the money, it is known as demand for money.
If the populations of one country want to hold the money, it is known as the demand for money of one country.
Money is referred to as liquidity assets.
The demand for money depends on income, interest rates and whether people prefer to hold cash as illiquid assets.
Money is demanded for financial transaction purpose because it acts as a medium of exchange.
The demand for money is equal to the total market value of all the goods and services performed.
It is the product of the total amount of goods and services (T) and the average price level (P).
Types of Demand for Money
There are three types of demands for money; they are explained below:
Transaction demand
All the financial transactions are done with money.
Money needs to buy goods and services in day to day life.
Transaction demand is related to income; peoples demand money upto their income.
In the classical quantity theory of money, the demand for money is a function of prices and income.
The classical quantity theory of money assumes the velocity of circulation is stable.
If income rises, demand for money will rise.
When wages and salaries are paid to the employees, they will hold some money to buy goods.
If they are paid once a month, they may deposit some money to take benefit from interest received.
Then they withdraw after few months.
However, the deposit and withdraw of money at the bank depends on income, expenses and savings.
Electronic transfers, banking app transfers and debit cards have made this less relevant.
Precautionary demand
Here, precautionary means safety, protective or defensive
We may need money for unexpected purchases or financial emergencies.
Money needed for unexpected purchases or financial emergencies is known as precautionary demand for money
Money needed for purchasing of assets is known as asset motive money
If the people have excess money than expenses, they want to buy assets or wealth.
This may occur during periods of deflation.
Speculative demand
When people wish to buy a risky investment, it is known as speculative demand
In speculative demand, they invest money in risky investments rather than buy assets or bonds (debentures).
Bonds or debentures have a fixed interest rate and maturity period.
If bank interest rates are low, people expect interest rates to rise.
When the bank interest rates are low, the price of bonds will fall.
In this case, demand for holding wealth in the form of money will be higher.
If bank interest rates are high, people will expect interest rates to fall.
When the bank interest rates are high, the price of bonds will rise.
In this case, demand for holding wealth in the form of money will be lower.
Click on the photo for FREE eBooks
Supply of Money
Money supply refers to the total volume of currency and bank money in circulation during a period of time.
In other words, it is the product of the total volume of money i.e. legal tender money and bank money.
According to this theory, other things being equal (T, V and V1 remaining constant),
There exists a direct and proportional relationship between money supply and price level
There is an inverse and proportional relation between money supply and the value of money.
In other words, other things being equal, the price level will also be doubled and the value of money halved and vice versa.
This theory is also explained in numerical form as follows:
Suppose, M = 1,500, V = 2, M1= 1,000, V1 = 1, T = 4,000 units
Then
P = MV + M1V1 ÷ T
= (1500 x 2) + (1000 x 1) ÷ 4,000
= 3,000 + 1000 ÷ 4,000
= 4,000 ÷ 4,000
= 1
Therefore, P = $1 per unit and value of money (1÷P) = 1
When the M and M1 are doubled
P = (3,000 x 2) + (2,000 x 1) ÷ 4,000
= 6,000 + 2,000 ÷ 4,000
= 8,000 ÷ 4,000
= 2
Therefore, P = $2 per unit and value of money (1÷P) = 2
When the M and M1 are halved
P = (750 x 2) + (500 x 1) ÷ 4,000
= 1,500 + 500 ÷ 4,000
= 2,000 ÷ 4,000
= 0.5
Therefore, P = $0.5 per unit and value of money (1÷P) = 2
The relation between money supply and price level, and money supply and value of money is summarized as follows:
|
Supply (M + M1) |
Price Level |
Value of Money |
|
1,500 + 1,000 = 2,500 |
1 |
1 |
|
3,000 + 2,000 = 5,000 |
2 (increase) |
0.5 (decrease) |
|
750 + 500 = 1,250 |
0.5 (decrease) |
2 (increase) |
Figure: Quantity Theory of Money
According to figure (A), OP is a 45° line showing a directly proportional relationship between the money supply and the price level.
Suppose, the initial money supply is OM1 and the price level is OP1.
When the money supply is halved from OM1 to OK the price level is also halved from OP1 to OP0 i.e. M1M0 = P1P0.
Conversely, when the money supply is doubled from OM1 to OM2, the price level is also doubled from OP1 to OP2 i.e. P1P2 = M1M2).
Thus, the OP curve shows the price level varies positively and proportionately with the money supply.
According to figure (B), RR1 curve slopes downwards to the right, as a rectangular hyperbola.
Suppose the initial money supply and values of money are OM1 and OR1 respectively.
When the money supply is halved from the OM1 to OM0, the value of money is doubled from OR1 to OR2 i.e. R1R2 = 2 (M1M2).
Conversely, when the money supply is doubled from OM1 to OM2, the value of money is halved from OR1 to OR° i.e. M1M2 = 2 (R1R2).
Thus, the RR1 curve shows that the value of money varies inversely and proportionately with the money supply.
Assumptions
The quantity theory of money is based on the following assumptions:
1. Velocity of money remains constant.
2. There is a constant volume of trade and transactions.
3. Price level is a passive factor.
4. Money acts as a medium of exchange.
5. There is a constant relationship between M and M1.
6. Long period.
Criticisms of the Quantity Theory of Money
Various economists like Marshall, Robertson, Keynes have criticized the theory of money.
Some criticisms are given below:
Unrealistic assumption
The theory of money is based on the assumption of long periods and full employment.
Keynes has remarked, “In the long run we are all dead; actual problems are short-run problems.”
Similarly, the assumption of full employment is also unrealistic.
Full employment is a rare phenomenon in the actual world.
In a modern capitalist economy, full employment and long period are unrealistic.
Static theory
The theory assumes that values of V, V1 and T remain constant.
But, in reality, these variables do not remain constant.
The assumption of constancy of these factors makes the theory a static theory and renders it inapplicable in the dynamic world.
Keep in Mind
|
T = Total volume of trade |
|
V = Velocity of circulation of the legal tender money |
|
V1 = Velocity of circulation of bank money |
Not independent variables
The various variables are not independent in assumes of the theory of money.
Change in M and M1 in itself may cause a change in V
Thus, cause a change in P more than in proportion to a change in M and M1.
Similarly, a change in M may frequently cause a change in T and a change in P may lead to a change in M.
Ignores other determinants
The quantity theory maintains that price level is determined by factors like M, V and T.
It ignores the importance of many other determinants of prices such as income, expenditure, investment, saving, consumption, population etc.
Ignored store value
The quantity theory of money considers money only as a medium of exchange.
It ignores completely its importance as a store of value.
Keynes recognized the store value function of money.
He emphasized the demand for money for a speculative purpose.
***** #EPOnlineStudy *****
Thank you for investing your time.
Please comment on the article.
You can help us by sharing this post on your social media platform.
Jay Google, Jay YouTube, Jay Social Media
जय गूगल. जय युट्युब, जय सोशल मीडिया
You might also like
Income Statement under NFRS | Balance Sheet under NFRS | P&S 1
Balance Sheet under NFRS | Statement of Financial Position under NFRS | Solution
Income Statement under NFRS | Profit or Loss Statement under NFRS | SOLUTION
Income Statement under NFRS | Balance Sheet under NFRS | EXPLANATION
Financial Statement under NFRS| Classification of Accounting Standards
Swar | Vyanjak | A Aa I Ee | Ka Kha Ga Gha | Ka Kaa Ki Kee | Barahkhadi | Kra Khra Gra
ABCD | British Phonetic ABCD | American Phonetic ABCD | ABCD in Devanagari
The Half-closed Eyes of the Buddha and the Slowly Sinking Sun | All Solution | NEB English Class 12 | Short Story Q&A
Comment box closed