Quantity Theory of Money Definition - Essay Example

?Introduction Money plays an important role in economic theory, with the supply and demand of money being variables affecting the macro economy greatly. There are different schools of thought in economics such as Keynesians, monetarists, and new classical. All the different schools of thought have different theories about money demand, and supply and monetary and fiscal policy. This report will focus on the neutrality of money, which is the concept that any change in the supply of money results in a change in nominal variables in the economy such as prices and exchange rates but does not have an affect on real income, employment or other real variables. Most schools agree on the long term neutrality of money, and the short term non-neutrality due to stickiness of wages among other factors. However, the schools differ in their theories of money and variables and policies that affect money demand and supply and other macroeconomic variables. Quantity theory of money The classical school of economists developed the quantity theory of money, which basically meant that the price level in the economy is dependent on the money supply. According to this theory inflation is caused by an increase in money supply. According to the theory that national income equals national expenditure the equation of the quantity theory is MV=PY, with V being the velocity of circulation, meaning the number of times in a year a unit of money is spent on buying goods and services, M being money supply, P being the price level and Y the national income. Classical economists through this theory asserted the neutrality of money by claiming that Y and V are exogenous factors and unaffected by the money supply with V being constant, thus P and M are directly related and changes in money supply would only affect the prices and not output. (Sloman, 1999) Keynes (1936) rejected the quantity theory of money by asserting that a rise in money supply may not necessarily lead to a rise in the price level. This may be due to the fact that the entire increase in money supply may not be spent and may just stay in bank accounts. The Keynesians claim the velocity of circulation is inversely proportional to M and thus the V in the equation may not be a constant. An increase in money supply may lead to an increase in output if there are unemployed resources in the economy. Thus an increase in the money supply can lead to an increase in Y, provided that the economy is not at full employment and not increase prices greatly. Similarly, a decrease in money supply could lead to a decrease in output and thus income causing a decrease in Y. According to Keynes, demand creates supply and not the other way round, which the Classical school believed. (Graham Sahaw, 1997) Milton Freidman was one of the most vociferous critics of the Keynesians, and brought back the quantity theory of money. According to him, inflation was anywhere and everywhere a monetary phenomenon based on his historical research. According to monetarists, any increase in money supply faster than an increase in output will lead to an increase in inflation. They asserted that V and Y are independent of the money supply and thus money supply will only affect prices and not income or velocity. According to the monetarists, an increase in money supply will increase prices along with employment and output in the short run, but as the economy adjusts to new prices and wages, in a couple of years output and income will adjust downward and the real effect of the increase in money supply will be inflation and vice versa with a decrease in money supply. (D.Mizen, 2000) The new classical theorists put forth the theory of rational expectations, which asserts that markets clear quickly and expectations adjust instantly to market changes. This theory assumes that people are aware of economic conditions and adjust their expectations accordingly. Thus, money is neutral in the short term as well as the long term, as expanding money supply will automatically lead to higher expectations of inflation and in turn causing inflation and not increases in output or employment. Thus, decreasing money supply to control inflation does not increase unemployment or output, these factors remain unaffected. (Sloman, 1999) THE TRANSMISSION MECHANISM According to the classical economists, the direct transmission mechanism would have no real effect on the income or output on the economy as a result of increase or decrease in the money supply. According to this theory, an increase in money supply will lead to increased demand for a limited number of goods thus increasing the price level. The price level in turn will rise till it fully accommodates the increase in money supply and the demand has been satisfied at the new prices. Thus real balances will remain unchanged and thus money is neutral. (D.Mizen, 2000) Price S S1 S2 (Supply for money) 1/P E 1/2P E1 E2 1/3P D D1 D3 (Demand for money) M 2M 3M Quantity of money The above diagram shows the classical view of the direct transmission mechanism. The demand curve is the demand for the real value of money and the price of money in terms of what money will buy. As money supply shocks shift the supply curve from S to S1 to S2, new equilibriums are reached from E to E1 to E2, which create a rectangular hyperbola proving that an increase in money supply which decreases price of money and increases demand for the real value of money. The hyperbola shows that as the supply of money increases to 2M and to 3M, the price of money falls to 1/2P and 1/3P showing that the real price of money stays at 1/P and money supply not affecting any change in real balances. The effects of changes in money supply explained through IS/LM and AD/AS curves: Most modern Keynesians and Monetarists believe that the monetary supply shocks are non neutral in the short run and neutral in the long run. Although new classical theorists believe that money is neutral in the short and long run. The short run effect: In the short run an increase in the money supply leads to an increase in national income as well as the price level. After an increase in money supply, agents have excess money supply that they will move into bonds which will shift the LM curve to the right, increase the price of bonds and decrease the interest rates. The decrease in the interest rates will result in an increase in investment, which will lead to a multiplied effect on expenditure causing it to increase greater than the increase in investment. This will cause an increase in aggregate demand (shift to the right) leading to an inflationary gap. Since in the short run, wages and input prices are sticky, firms will increase output. The rise in the price level will increase the price of goods, decrease real wealth and decrease real money supply. This will result in corresponding shifts in IS/LM curves to reach a new national income level. (lipsey, 1995) Interest rate LM LM2 LM1 I I2 I1 IS1 IS National Income Y Y2 Y1 Price SRAS (Short run average cost curve) P1 P AD1 AD (aggregate demand) Y Y2 Y1 National Income The assumption is that Y is full employment level in this case. As can be seen by the interaction of the IS and LM graphs and the AD and SRAS graphs, an initial increase in money supply will shift the LM curve to LM1 and decrease interest rates which will in turn increase aggregate demand to AD1 due to an increase in investment and expenditure. Thus the money supply shock results in an inflationary gap. However, the increased aggregate demand causes suppliers to increase production in the short run to satisfy the demand, but the increasing prices also cause shifts in the IS/LM curves causing movement up the AD2 curve causing price levels to shift to P2 and income to Y1. (lipsey, 1995) Long Run: Interest rate LM LM2 LM1 i IS IS1 National Income Y* Y2 Price LRAS ( long run average supply curve) SRAS1 SRAS P2 P1 P AD1 AD (aggregate demand) National Income Y* Y2 The IS and LM graph and the AD and LRAS graph shows the long run effect of an increasing money supply. As mentioned in the short run, input prices do not change and the economy starts operating at Y2. However, in the long run when actual output is greater than potential output and prices have risen, employees will be facing a decrease in real wages which will cause them to demand higher wages, other costs of raw materials will also rise. Thus, the SRAS curve will shift to the left to SRAS1 further causing prices to rise. The increased price level will cause the real money supply to shrink thus causing LM to shift to the left to LM2 and due to decreasing wealth and increased prices of local goods compared to imports IS will also shift to IS1 thus Y1 will fall to Y* (potential output). It will cause a movement on the AD curve with equilibrium being reached at Y* P2. Thus there is no long term effect on income and output of an increase in money supply. An increase in money supply in the long term leads to inflation and income remains constant. When income falls to Y*, the increased employment in the short run due to increased output would also decrease causing employment to fall to natural levels. Thus, in the long run money supply does not affect national income and it is neutral. Keynesians Vs. Monetarists Although the Keynesians reject the quantity theory of money and monetarists accept a modified version, they both agree on the non neutrality of money in the short term and neutrality of money in the long run. However, Keynes established money as a non neutral factor in the sense that it allows people to protect themselves and take advantage of opportunities. Keynesians feel that although money is an important factor, it is not an important policy tool and tend to focus towards fiscal policy to affect output and expenditure. They distinguish between the financial and real sector and consider money as another financial asset. Whereas monetarists discount the fiscal policy as an effective tool, asserting that it just reallocates resources from the private sector to the public sector. Monetarists assert that investment is responsive to interest rates, and an increase in money supply will lead to a great increase in aggregate demand but this increase will be reflected in high prices only. Whereas, Keynesians focus on expenditure, monetarists focus on monetary policy to reduce inflation. Generally, Keynesians argue that the demand for money is not dependant on interest rates and rather on precautionary, speculative and transactional demand for money thus investment is not very responsive to changes in interest rates which will result in an increase in money supply having a small or no effect on aggregate demand if there is full employment. The Keynesians believe that at low rates of interest, changes in rate will have no effect on investment or demand for money and thus no effect on aggregate demand. This is known as the liquidity trap. (Fillho) Interest rate i Liquidity trap Demand for Speculative money Demand for money Rational expectations theory This theory based in the new classical school of thought is applicable practically in financial and commodity markets where there are efficient information systems and agents are aware of all information. However, since efficient markets do not exist generally, this theory has limited applicability. The theory assumes that agents in the economy take decisions based on all gathered and perused information for the future. They make rational decisions and only make marginal errors at times. This theory also assumes that prices will always adjust and markets will always clear. With regards to the neutrality of money, this theory holds the new classical idea that money is neutral in the short and long run, as when money supply increases, employees and consumers are aware of this and will expect inflation and input prices will rise without a lag thus money is neutral. (Shaw, 1986) Conclusion Most economists agree that money is neutral in the sense that changes in money supply do not affect real variables such as output, employment and income rather it only affects nominal variables such as prices, exchange rates, wages. Almost all economists agree that money is neutral in the long run whereas Keynesians and Monetarists agree that money is non neutral in the short run and may increase output and employment in the short run but in the long run output will remain the same. New Classical economists however on the basis of their rational expectations theory believe that money is neutral in the short and long run. References A Review of Keynesian Theory. (n.d.). Retrieved 3 9, 2011, from http://www.huppi.com/kangaroo/Keynesianism.htm D.Mizen, M. K. (2000). Monetary Economics. Fillho, F. F. (n.d.). “KEYNESIANS”, MONETARISTS, NEW CLASSICALS AND NEW KEYNESIANS: A POST KEYNESIAN CRITIQUE. Retrieved from http://www.scribd.com/doc/9015768/keynesians-Monetarists-New-Classicals Fontana, G. (2001, 10 4). Keynes on the "Nature of Economic Thinking": The Principle of Non-Neutrality of Choice and the Principle of Non-Neutrality of Money - Focus on Economic Theory - John Maynard Keynes. Retrieved 3 8, 2011, from http://findarticles.com/p/articles/mi_m0254/is_4_60/ai_80802014/pg_13/?tag=content;col1 Graham Sahaw, M. J. (1997). Macroeconomics: theory and policy in the UK. lipsey, R. (1995). Positive Economics. Vancouver. Mises, L. V. (n.d.). Money, Method, and the Market Process Ch 5. Retrieved 3 9, 2011, from http://mises.org/mmmp/mmmp5.asp Monetarism and Other Schools of ThoughtIs Controlling The Money Supply The Answer?? (n.d.). Retrieved 3 9, 2011, from http://www.zahablog.com/?page_id=352 Monetary Transmission Mechanism. (n.d.). Retrieved 3 9, 2011, from http://www.newschool.edu/nssr/het/essays/monetarism/monetransmission.htm Shaw, G. (1986). Rational Expectations: An Elementary Exposition. Sloman, J. (1999). Economics. The Neutrality of Money. (2002, 11 6). Retrieved 3 9, 2011, from http://www.goldenbar.com/Briefs/06Nov02Editorial.htm The No Classical-Keynesian Synthesis. (n.d.). Retrieved 3 9, 2011, from http://www.newschool.edu/nssr/het/essays/keynes/synthesis.htm The Post Keynesian School. (n.d.). Retrieved from http://econ.bus.utk.edu/faculty/davidson/vanemssword2pd.pdf The Quantity Theory of Money: From Locke to Keyes and Friedman. (n.d.). Retrieved 3 9, 2011, from Southern Economic Association: http://www.thefreelibrary.com/The+Quantity+Theory+of+Money%3A+From+Locke+to+Keyes+and+Friedman.-a018858313 Read More