Macroeconomics: Money and Banking - Essay Example

Macroeconomics: Money and Banking Introduction Macroeconomics is the part of economics that deals with the economy as a whole, as opposed to microeconomics that deal with individual industries and sectors. Fluctuations in the economy as a whole, that is, in aggregate output, cause fluctuations in the unemployment rate, interest rates, and average prices. Monetary theory studies the demand and supply for money and the natural tendency of the macroeconomic system to balance the supply and demand to reach monetary equilibrium (Thurman, 2006). The figure below shows the diagrammatic representation of monetary equilibrium. The aggregate demand curve (AD) describes the total volume of aggregate expenditures in the economy at different price levels. At each point on the AD curve, the underlying goods and money markets are in equilibrium for that price level. The Aggregate Supply curve (AS) describes the aggregate output in the economy at different price levels. It depicts how firms will wish to change total volume of output as prices change. Both AD and AS are macro concepts and are variables of the economy as a whole. As a result, price level entails all prices in the economy and the expenditure of one person becomes the income of another. Figure 1: Aggregate Demand & Supply 1 Source: Moffat, Mike, ‘Aggregate Demand & Aggregate Supply Practice Question’, About: Economics The equilibrium level in the macro economy will be where the desired total level of expenditures in the goods markets exactly matches the desired total level of output that firms in the economy wish to sell. Thus, we will get the equilibrium price level and equilibrium income in the economy where AS = AD. Excess money supply in the economy causes a drop in the value of money which in turn leads to rise in the prices of goods. This phenomenon id referred to as inflation. Inflation reduces the demand for money, the extra money flows into other investments that contribute to the growth of the economy. When the economy expands, the demand for money grows again, and thus, the economy attains monetary equilibrium (Thurman, 2006). The demand for money theories revolve around the concept that the level of prices in an economy is determined by the quantity of money. These theories study the different ways in which the quantity of money affects the level of prices and what these effects are of the changes in the quantity of money. The two theories considered in this study are the Keynesian and Monetarist theories of money demand. Monetarist Theory Milton Friedman, a prominent American economist during the mid and late 1900s, formulated the Monetarist theory of demand for money. Friedman, who started as a Keynesian supporter, moved to the right during the 1950s and strongly believed in capitalism and a liberal economy with no government intervention. Monetarist theory advocates that inflation is destructive to an economy and excessive money supply is the root cause of inflation in an economy. Inflation can thus be contained using monetary policies and tight control of money and credit is required to maintain price stability. According to this theory, velocity of money should be the principal objective of a monetary policy. Velocity of money is defined as the rate at which money is exchanged from one transaction to another and is computed by dividing the nation's output of goods and services (GDP) by the total money supply (MS). Monetarists believe that prices should be a function of demand and supply and hold that since changes in the demand for money are small relative to changes in money supply, most of the changes in the general price level are caused by money stock changes (Hetzel, 1984). The monetarist argues that the demand for money is a stable function and fluctuations in aggregate demand and price level are the result of imbalances between demand and supply of money. Keynesian Theory Keynesian theory is an economic theory based on the ideas of the British economist of the 20th century, John Maynard Keynes. Keynesian theory puts more emphasis on aggregate demand and its effects on output and inflation. The theory advocates that aggregate demand is an equation of various components such as consumption, investment, government spending, savings, taxes, imports and exports. According to Keynesian theory, changes in aggregate demand, whether anticipated or unanticipated, have their greatest short-run impact on real output and employment, not on prices. Keynesians believe that, because prices are somewhat rigid, fluctuations in any component of spending such as consumption, investment, or government expenditures cause output to fluctuate. If government spending increases, for example, and all other components of spending remain constant, then output will increase (Blinder, CEE Article). Keynes also believed that government is responsible for helping an economy by increasing their spending at times of depression, which will in turn encourage people to spend more. This increases the money supply and the demand for money. Keynesians give money an important yet lesser role in the determination of aggregate demand and prices. Keynes distinguished three motives for holding money: 1) transaction motive to meet normal day-to-day needs, 2) precautionary motive for unforeseen expenses and 3) speculative motive for speculative financial transactions. Theories of demand for money The Monetarist theory is based on the Quantity Theory of Money introduced in the 1700s. According to this theory, MV = PY where M is money supply, V is velocity of money, P is price level and Y is real GDP. This equation was first introduced by Irving Fisher and is called the Equation of Exchange. The Quantity theory advocates that with velocity and real GDP remaining constant, an increase in the supply of money will lead to a proportionate increase in the price level. Thus, money supply expansions cause only price inflation. Fisher further explains his theory by stating that if money increases and velocity and real GDP are fixed, then the money supply will be greater than the money demand. This leads to a potential increase in prices until the demand is pulled up to match the supply and equilibrium is attained. Therefore, Fisher’s Quantity Theory of Money supports that increase in money supply will be met by a proportionate increase in price levels in the economy. This theory implies that no other factor, including interest rates, have any role to play in the quantity of money. The Keynesian theory, however, is supported by the IS/LM Model, introduced in the 1930s by John Hicks and Alvin Hansen. This theory studied the interaction between the real market and the financial market. From the real market, the level of income is extracted, whereas the interest rates are extracted from the money market. These factors affect other variables in the market, with income affecting demand for money and interest rates affecting investments. This model holds that total planned expenditure, i.e., aggregate demand, is a function of consumption, investment and government spending and aggregate supply or income is the function of consumption, savings and tax. To attain equilibrium, AD should equal AS. Thus assuming a balanced budget which equates government spending and taxes collected, the equilibrium state can be re-written as planned investment equals planned savings in an economy. Monetarist vs. Keynesian Both Monetary as well as Keynesian theories are concerned with how money affects the aggregate demand for goods and services, as opposed to aggregate supply. Friedman’s theory disagreed with the Keynesian theory on the bounds that changes in nominal demand would lead to durable changes in real output, fixed propensity to consume out of current income drove aggregate demand and the power of the fiscal policy and the government in controlling the economy. Keynesian theory advocates liquidity preference, i.e., people prefer to hold money rather than any other form of wealth. But according to monetarist theory, people hold other assets such as equities and bonds as well. While the Monetarist theory holds that interest rates have little or no effect on aggregate demand, Keynesian theory states that interest rate is a variable of the monetary market and therefore affects investments in an economy. Keynes assumed that wealth would be held either as cash or as bonds and the determining factor between the two would be the interest rates. But the Monetarists expanded the form of holding money and included other avenues of investment such as equities, real estate along with bonds. Monetarists held that an increase in the rate of return from any one of the investment avenues would be offset by a compensatory decrease in the other rates and hence the Monetarist believes that aggregate demand stays stable. Keynes, however, believes that demand for money is unstable because of changing investor preferences. While the Monetarist believes that price is a function of demand and supply and hence price is determined by the market forces, the Keynesian theorists held a strong confidence in the exercise of discretion by the government. The monetarist theory says that setting annual targets for growth in the money supply is the best means to achieve stable growth in the economy and control inflation. According to the monetarist view, the velocity of money is the most important factor influencing economic growth. The theory ignores other factors, such as government spending and taxation and bank credit, which are equally important. Up until some decades ago, Keynesians argued that monetary policy was powerless, and monetarists argued that fiscal policy was powerless. But today, nearly all Keynesians and monetarists believe that both fiscal and monetary policy affect aggregate demand. Empirical evidence shows that demand for money is highly sensitive to interest rates. Investments and not just liquidity, is essential for the growth of the economy and to maintain the monetary equilibrium. When interest rates are high, people put more money in interest paying instruments whereas when interest rates are low, they hold more money in cash. Even though the economy has moved towards a more liberal and global state, the government still regulates the economy on a large scale. The central bank of a country controls the movement of interest rates to a large extent, which is required to keep inflation in check and prices of goods more or less stable. Demand for money is definitely not stable; factors such as exchange rates and new financial innovations are probably the most likely sources of money demand instability. The rapid pace with which technology is growing throws open more and more avenues for economic growth. The vagaries of floating exchange rates could even spell out another monetary integration; like a world currency. References Molly Thurman. (2006). Monetary Theory. E-articles.info published on 23 September 2006. Retrieved May 8, 2007 from http://www.e-articles.info/e/a/title/Monetary-Theory/ Hetzel, Robert L. (1984). A monetarist money demand function. Economic Review. Nov/Dec, pg: 15-19. Moffat, Mike. Aggregate Demand & Aggregate Supply Practice Question, About: Economics. Retrieved May 8, 2007 from http://economics.about.com/od/aggregatedemandsupply/ss/aggregate_5.htm Blinder, Alan S. Keynesian Economics. The Library of Economics and Liberty, Retrieved May 8, 2007 from http://www.econlib.org/library/Enc/KeynesianEconomics.html Read More