Quantity Theory of Money - Example

Quantity Theory of Money Introduction The modern economics have sole value money in terms of bank deposits. However, there has been confusion on how these bank deposits are created. Many banks create money through lending; however, they do so within particular limits. Mainly, banks hold household savings that invest in order to generate money. Central bank remains an integral component of the economy in regulating money circulation, besides through prudent money flow regulation the value of money is guarded against excruciating effects of inflation. This essay will correct misconception of money, discuss how money is generated and role of banking institutions in regulating household money. Secondly, his paper will examine the quantity theory of money, Keynesian economics and classical theories of modern economics. Concept of Money Creation Parguez (2014) states that one of the leading misconception is that banks are just intermediaries that lend, deposit and save money from households. There has been poor understanding of stock of bank deposits, in reality when household saves cash; it does not necessarily increase the amount of money in circulation. The assumption that banks are intermediaries of cash flow is misleading. In modern economies, commercial banks are creators of deposit money. Today, the banks lending act has created immense available cash for lending rather than the assumption that banks wait for household deposits to lend. Graphical Representation of Money Stock and Borrowing In England banking system, money creation is through the broad money determination concept. Rather than lending consumers deposits, the modern economic concept operates on creating cash available for lending out through the act of lending. Broad money refers to the total bank deposits that were initially held by the households. In addition, broad money comprises of bank deposits that make about 97% of money in circulation (Parguez 2014). According to the modern economic theory, this money is often created by the existing commercial banks. Another common misconception on how money is created is that the central bank determines quantity of loans and deposits in the economy. In modern economic theory, central banks implement monetary policies based on a set minimum reserve. Bank reserve is the minimum threshold that should be held by the bank; this value is used in calculating how much lending and deposits can be made in the banks. The central bank regulates bank reserve and the borrowing rates. In addition, Fontana (2003) states that money is created in modern economics through the repayment of loans from the households. In essence, money creation is through liability for consumers. When banks give loans to its consumers, it becomes a way of generating more cash available for lending. There are three major constraints that limit the money that the banks can create. Graphical Representation of Loanable Funds Firstly, commercial banks face lending limitation due to market competition. Before lending, the banks should be able to have a guarantee of profitability. Besides, banks face serious risks mitigation strategy that limits the amount of money available for loan. Secondly, money creation is limited by the uncertainty of households and companies that receive the newly created cash. Thirdly, monetary policy limits the amount of commercial banks lending. By setting interest rates, the Bank of England monetary policies limit household lending (Howells 2007). This is an important step in destroying circulating cash and subsequently regulating the amount of cash in circulation. Bank of England and Monetary Policy Parguez (2014) states that the primary goal of existence of Bank of England is to regulate currency and foster stability in money in circulation. One way is by setting interest rates that often pay attention to the existing amount of money in circulation. Today, the consumer inflation target set by English government of 2% and the Bank of England ensures that this level is not exceeded. Relationship between Supply of Money and Bank Interest Rates However, there are two things that happen to the newly created cash; firstly, the households and businesses either destroy it by paying outstanding loans often called "reflux theory." Secondly, the extra money encourages more consumer spending in the economy. Destroying this new cash through reckless expenditure increases the cash in circulation. In essence, monetary policy adopted should determine the amount of circulating and money creation. In modern economic theory, the central bank is integral in an encouraging or discouraging creation of money by the commercial banks (Rachon & Rossi 2007). The Bank of England remains acts as the sole regulator of the cash created and that in circulation. Any mismatch results in inflation, a phenomenon that has been argued as a common eventuality of any money economy. Keynesian Economic Theory Perhaps the Keynesian theory explains best how money can be regulated in the economy. The cash in circulation is determined by interest rates and private sector decisions to save their disposal cash. Keynesian theory suggests that private sector actions cause macroeconomic outcomes that now demand active policy creation and enforcement by public sector. Published in 1963, the theory examines how money in economic can be controlled (Fontana 2003). In his theory, Keynes argues that in order to stabilize the economy, there should be inducers to invest and combination of reduction of interest rates and government expenditure through infrastructural investment (fiscal policy). Keynesian Theory Graphical Analysis Keynesian theory has been widely adopted by the Bank of England over many years through its monetary policy that regulate the quantity of money in circulation. In essence, Keynesian theory has a number of assumption that depicts how money in the economy can be regulated. This theory stipulates that both public and private sector determine the aggregate demand, which is total spending in the economy. However, the theory argues that the existing monetary policy has little control in regulating household spending. Some economists argue that the quantity of money in circulation largely influences amount of cash available for spending. However, today the theory recognizes that both the fiscal and monetary policies influence the aggregate demand. In addition, the theory recognizes the role of employment in increasing amount of money within the households. In line with modern economic theories, Keynesian theory argues that any changes in aggregate demand, whether anticipated or not would have greatest short-term on output and employment in the economy but not on prices of products. Furthermore, the multiplier effect is an important concept of Keynesian theory. Multiplier effect states that output increases as a result of multiple spending. The banks raise independent lending cash through utilizing this concept. In practice, the quantity of cash in circulation is seen to increase substantially as a result of a number of transactions. Two features of Keynesian theory holds that people receive money and spend most on goods and save the remaining. Secondly, the spending increases the amount of money available for businesses that in turn increase consumer spending. The concept of quantity of money is increased by employment rates. Notably, the theory holds that, unfortunately, the salary and wages in the economy are rigid. While studying the quantity of money, Keynesian position state that even in established economies like United States, aggregate demand is severely affected money in circulation. Post Keynesian Theories and Classical Economics Rachon & Rossi (2007) identify that Eichner and Kregels economics school of thought forms post-Keynesian era. These economists held neo-Keynesian economics and neoclassical economics. The theoretical foundation that explains the concept of quantity of money in circulation rests on the concept of effective demand. It has been a concept that has defined microeconomics concept through 1980s to the modern economics. In the 21st economics, endogenous money is mostly credited money. The first stage is to know how money is measured in order to exemplify the endogenous concept. In United States, for instance, money is measured in two main ways. Firstly, through a high-powered system that is also called the monetary base. This consists of the currency in circulation. This currency could be the required or excess reserves that include notes and coins. Secondly, is the broad money that includes currency circulating outside bank vaults. The quantity of money in circulation includes cheques, electronic funds, debit cards and another form of high-powered money. The recent years has seen a high transaction using high-powered money, although clearing these transactions take substantial time, they remain an important determinant of money in the economy. The demand deposit is now a major component of the money supply to the economy and encourages spending by household. It is money created by banks in response to the increased demand for cash. There are two critical factors affecting the creation of money using endogenous money. Firstly, the newly created bank deposits introduce additional base money in the bank and thus the money deposited becomes banks money. In such circumstances, there is additional cash into the banks. Secondly, creation of deposit demand accounts for bank credits. In theory, base money creation is created by the central bank through the money multiplier. Moreover, the changes in prices of factors of production cause an increased demand for money leading to high demand for borrowing. The cost of production is an important determinant in determining the amount of money in circulation, and it is an important feature in macroeconomics (Parguez 2014). Conclusion Creation of money coupled with integration of Keynesian and post-Keynesian theories help to understand how money circulates in the economy. The Bank of England and commercial banks regulate amount of money in the economy through monetary policies and interest rate adjustments on borrowing. Through multiplier and lending operations, commercial banks generate money for lending. Thus, banks do not rely on household deposits to create money. References List Fontana, G. 2003. Post Keynesian Approaches to Endogenous Money: A time framework explanation. Review of Political Economy. doi:10.1080/09538250308431 Howells, P. 2007. The Demand for Endogenous Money: A Lesson in Institutional Change. Parguez, A. 2014. Money Creation, Employment and Economic Stability: The Monetary Theory of Unemployment and Inflation. Panoeconomicus. doi:10.2298/PAN0801039P Rochon, L., & Rossi, S. 2007. Central Banking and Post-Keynesian Economics. Review of Political Economy. doi:10.1080/09538250701622402 Read More