The Quality Theory of Money in its Effects in the Domestic Price Level and on the Exchange Rate - Example

The Quality Theory of Money in its Effects in the Domestic Price Level and on the Exchange Rate Name Institution Name Course Name and Code Date In an economic situation, numerous processes influence the economic activities. Money is the medium of exchange and numerous purchases and sales are based on money. To prevent economic problems, it is important to manage the amount of money in the economic market. The government is tasked with releasing funds, which may affect inflation and prices of the products and services. The increase in money in the market also affects the exchange rate. Numerous theories, frameworks and policies discussing money and effect of money in the market are numerous. An example of such theory is the quantity theory of money. The quantity theory of money states that a direct correlation exists between the quantity of money and the prices of goods and services in the economy. A general view of the theory is that doubling the amount of money in the economy results in doubling in the price of goods and services, which translates to inflation. The aim of the essay is to discuss the quality theory of money in its effect in the domestic price level and on the exchange rate. The quantity theory of money is premised on the changes associated with an increase in the money supply. The quantity of money is based on the value of money since it is centered on the amount of money in the economy. When the government financial institutions increase the money supply, the price level increases while the value of money falls (Barthalon, 2014). It incorporates aspects of inflation since the increase in price level results in inflation. Focusing on this definition, the quantity theory of money is viewed as a primary cause of inflation because of money supply growth. If the movement of money is controlled through effective and efficiency policies, problems such as inflation can be addressed easily. The entire quantity of money may be associated with the value of money. The effectiveness of the quantity of money is based on the power of the money. Similar to numerous economics, there is a market for money (Einzig, 2014). The supply and management of money originate from institutions such as the Bank of England through adjusting the money supply by decreasing and increasing the number of bills in circulation. However, the demand for money in any economy is from the customers. The customers drives the economy activity through employing processes to increase the amount of money. The increase includes improving the production processes and other procedures, which makes consumers to have additional money to use in the market economy. In determining the quantity of money is a challenge because it is infinite. It is premised on the understanding consumers requires money to acquire services and products. In instances of the presence of credit card or ATM, the consumers can demand less money to carry compared with the difficulty of obtaining (Einzig, 2014). The important component to determine the amount of money demanded is the average price level within a market economy (Barthalon, 2014). If the cost of a service or goods is high, the consumers will demand more money to acquire these products and services (Mishkin, 2016). If the average price level is lower, the customers will require less money to acquire the products. In the entire process, the value of money against the quantity of money influences the price level of goods and services. The following figure illustrates the demand and supply of money to influence the price of products and services. Sample of Money Market Figure* *Note the value of money moves from low to high while the price of money is from high to low in the above figure The figure depicts the movement of money in a market economy whereby the intersection of consumers’ money demand and government control presents the value of money and price level (Einzig, 2014). Let’s call the government institution is the Fed that controls the financial policies; the demand curve is vertical in nature because the Fed controls the availability of money without incorporating the value of money. The money demand curve slopes indicating that the value of money is decreasing meaning the consumers are required to have more money to acquire services and goods since it costs more (Barthalon, 2014). While the value of money increases, the price of goods and services decreased. The intersection between the money demand curve and money supply curve indicates the equilibrium value of money and by extension the price level equilibrium. Based on the analyses, the value of money is seen as a variable in the money market. A change in money supply or a change in money demand results in a change in the price level and the value of money. The changes are either positive in reduction of price of goods and services or negative in increase of prices and goods. The aim of financial institutions is to reduce the cost of products and this is possible to manipulating and adjusting the monetary system and processes. The “Sample shift in the money market” (figure below) shows changes in money supply and money demand. New Sample of Money Market Figure: Changes in Money Supply The figure illustrates an increase in money supply, which affects the value of money. In the figure, the money demand and money supply intersection are lower meaning the value of money is also lower. It is attributed to more money circulating in the market, but each pound purchase becomes more worthless. More pounds are required to purchase services and goods; hence, more money is required to purchase which translates in an increase in price. The increase in prices also means forgoing some important market requirements and products and services that the customers want. The customers will be required to acquire same products and services but at higher price. The association of value of money, the price level, money demand and supply is accurate since these variables are not connected directly with the aspect of the quantity of money (Barthalon, 2014). Rather, numerous variables influences the money demand and money supply contributing to the changes (Einzig, 2014). In understanding the quantity theory of money, the money supply, the purchasing power parity and demand framework illustrates how monetary policies are transmitted to the price level (Mishkin, 2016). The framework for understanding the quantity of theory of money has a meditator, which is the velocity of money that is given by the following equation: MV = PY Where: M = Money Supply V = Velocity of circulation of money P = Price Level Y = Full employment output, As Y and V are constants, the equation can be rearranged to present: P = 1/v(M/Y) The velocity of money is defined at the rate at which money moves from one individual to the next individual. Instances of high velocity whereby money changes hands at a faster rate, and the presence of small money supply, the money is able to acquire large amounts of services and products. Conversely, when the velocity is low meaning the money changes hands slowly, it requires more money to purchase similar products and services (Mishkin, 2016). It is imperative to note the velocity of money is flexible and depends on consumers’ preferences changes. The velocity also fluctuates when the price level and value of money change. If a constant money supply is maintained, the speed of movement of money should increase to fulfill the requirements of purchase: the Fed can also influence the velocity of money. The velocity of money equation is appropriate in the original form but can be altered based on the available information and expectations for easier calculations. Sometimes, the equation is converted into percentage whereby the variables such as money supply, change in velocity, price level, and output can be given in percentage format (Einzig, 2014). The aim is to ensure the numerous variables are based on common units. The velocity of money equation is sometimes utilized to find the effects that change in money supply, price level, or velocity have on each other (Mishkin, 2016). It is imperative to remember that the output (Y) remains constant for the short term. However, the output variable can be changed depending on the study and period under review. To understand the significance of velocity and money supply, an example is provided. For example, what is the effect of an increase of 10% in the money supply on the domestic price of a product or service provided the velocity and output remain constant. The applicable equation is money supply + change in velocity = price level change + output. In substituting the variables for the provided percentage, we obtain 10% + 0% = x% + 0%. The answer is 10%, which means the price level as increased by 10%. It is crucial to note an increase of 10% in price levels means the inflation was 10%. This analysis is important in analyzing the quantity of money, but the equation is more applicable when analyzed for long periods. For long periods, an increase in funds from government institutions tends to increase the price level resulting in an increase in inflation. Sometimes, the government decisions to increase the money supply is addressed by the velocity of money. These changes are attributed to numerous processes in the utilization of the excess funds (Mishkin, 2016). For example, the velocity (V) remains constant over time because it becomes difficult for consumers to change their spending habits quickly (Barthalon, 2014). The output variable (Y) also remains constant because the amount of product remains the same but what may change is the value of the goods or service produced. From the analysis, it may be argued that the percentage of price level and money supply equals because the percentage of output and change in velocity are both equal to zero. Therefore, the government increase in money supply directly results in inflation, which may affect other sectors of economy if mitigation and protection strategies are not incorporated in the economic processes. The money supply affects economic inflation. Let’s use an example to understand the influence of money supply on inflation. What is the effect of the increase of 7% in on the economy from the perspective of inflation? Through the use of the previous equation: money supply change percentage + velocity change percentage = price level change percentage + output percentage. Since the approach taken is long term, the decision of the government and velocity remains constant. The equation becomes 7% + 0% = x% + 0%. The analysis indicates that an increase of money supply by 7% results in an increase in inflation by 7%. Therefore, the exchange rate is affected because when the inflation increases, the customers will use the same amount but be able to acquire less products. The exchange rate has been discussed indirectly throughout the article. The exchange rate is viewed as the monetary exchange for the products and services. Normally, common units are used to quantify the products and services in monetary terms, and these calculations are affected by the amount of money supplied. For example, 10 pounds can be used to exchange for a bag of sugar. However, the decision by the government to increase money results in the 10 pound purchasing less amount of sugar. The exchange rate is affected because more money will be required to acquire the same amount of product or service. Even though the money supply may not affect other monetary functions, the aspect of inflation may create a multiplier effect, resulting in disabling the economy. The economy relies on the stability of prices, and changes should reflect competition and other market-oriented forces. Some governments believe the increase in money supply improves the economy, but the problem comes to the velocity of the money (Einzig, 2014). Concerns on inflation and mitigation of inflation are important in sustaining the requirements of the economy. Governments employ certain techniques to address the amount of money supply to prevent its effect on the economy (Barthalon, 2014). The government may mob the funds through purchasing the excess liquidity in instruments such as T-bills and bonds. Removing the money from the market reduces the amount of available funds, which also means the value of the money is improved (Mishkin, 2016). Improvement of value forces consumers to use less amount of money to acquire a product and service. Therefore, the government plays an important role in controlling the money supply and can institute numerous processes to prevent inflation. The examples and discussions illustrate the significance of velocity of money equation in representing quantity theory of money (Barthalon, 2014). The velocity plays an integral component in mitigating government actions in the short run and ling run, and through the analysis, it is possible to appreciate inflation and value of money. The government may also employ approaches such as infrastructural development to manage the money supply. The government investments create employment, and practices of employment affect the inflation and production processes. In conclusion, the quantity theory of money presents important information on the effects of money on the domestic prices and exchange rates. In quantity theory of money, numerous variables are incorporated such as the velocity of money, price value, the value of money, money supply, and money demand. When the value of money is high, the prices of products is low while a weak value of money translates to increase in prices. In addition, the increase in the supply of money in the market reduces the value of the money and equilibrium is reached when the demand and supply of money intersects. The important component is the velocity of money whereby the movement of money among individuals is analyzed. The faster the movement of money, the more the products and services an individual can acquire. However, the slow velocity of money results in slow movement of money, which means fewer products and services are acquired. An individual will be required to use large sum amount of money to acquire a product and service compared with instances of high velocity of money. Inflation and exchange rates are also affected by money supply and the role of the government. The government creates policies and releases money to the market. When the government releases large amounts of money while the output remains constant and the velocity, inflation occurs. The increase in prices of products results in an increase in inflation because of supply of money. Removing excess money from the market is important since inflation and prices of goods and services are managed effectively. References Barthalon, E., 2014. Uncertainty, Expectations, and Financial Instability: Reviving Allais's Lost Theory of Psychological Time. Columbia University Press. Einzig, P., 2014. Monetary Reform in Theory and Practice (Routledge Revivals). Routledge. Mishkin, F. 2016. The Economics of Money, Banking and Financial Markets (11th Edition). The Pearson Series. Read More