Chapter 32: Monetary Theory
Introduction
- Monetary theory deals with the effects of the demand and supply
of money on income, output, and the price level.
The Quantity Theory of Money
- The Quantity Theory of Money states that price level changes are
due to changes in the quantity of money.
The Crude Quantity Theory of Money
- The crude quantity theory states that the money supply is
directly proportional to the price level.
The Velocity of Circulation of Money
- The Velocity of Circulation is the number of times, on average,
that a unit of money is spent per year in purchasing final goods
and services.
- Velocity of Circulation = GDP/Money Supply
- Real GDP = GDP/Price level or GDP = Price level X real GDP
- GDP = P X Q
- V = GDP/M = (P X Q)/M
The Equation of Change
- The Equation of Change is an important element of the quantity
theory of money.
- The equation of exchange can be expressed as the following
identity: MV = PQ
o The Theory
 The money supply is exogenously by the monetary
authorities. Hence M is given.
 V, the velocity of circulation, is determined by
institutional factors such as the payment habits of
individuals and the frequency of receipt of income,
and is therefore independent of M, P, and Q.
Therefore V is constant
 Real gross domestic product, Q, would therefore
remain fixed at the full-employment level, at least in
the short run.
- M = Q/ V X P
- The price level is determined by the money supply. Changes in
the money supply cause proportional changes in the price level.
Limitations of the Crude Quantity Theory
- The assumptions of a constant velocity of circulation and
constant output are the main weaknesses of the crude quantity
theory.
- The velocity of circulation in Canada has moved steadily upward
over the years.
The New Quantity Theory (Monetarism)
- The new quantity theory links the money supply to nominal
income.
- M = (1/V) (P X Q)
- The main conclusions of the new quantity theory are:
o The demand for money varies directly with the price level.
o Real income is an important determinant of the demand
for money.
o There is a consistent direct relation between the money
supply and the growth rate of nominal income.
The Keynesian Theory of Money
The Transactions Demand for Money
- The Transactions Demand for Money depends on the level of
income.
The Precautionary Demand for Money
- The Precautionary Demand for Money depends on the level of
income.
The Speculative Demand for Money
- The speculative demand depends on the rate of interest.
The Total Demand for Money
- Liquidity Preference is the desire to hold money rather than less
liquid assets.
- The Liquidity Preference Curve shows that as the rate of interest
falls, the amount of money that people will hold increases.
Effect of Changes in Income on the Demand for Money
- An increase in income causes the demand curve for money to
shift to the right; a decrease causes the curve to shift to the left.
Interest Rate Determination (Liquidity preference theory)
- The equilibrium rate of interest occurs at the intersection of the
demand and supply curves for money.
Changes in the Money Supply and Net Domestic Income
Effects of an Increase in the Money Supply
- An increase in the money supply causes the rate of interest to
fall. The fall in the rate of interest increases investment, which,
in turn, increases net domestic income.
Effects of a Decrease in Money Supply
- A decrease in the money supply causes the rate of interest to
rise. The increase in the rate of interest reduces investment
which, in turn, reduces net domestic income.
Keynesians Versus Monetarists: A Brief Summary
-
Keynesians and monetarists agree on the following points:
o An increase in the money supply results in an increase in
net domestic income. A decrease in the money supply
results in a decrease in net domestic income.
o An increase in the money supply, in a situation of less than
full employment, causes real output to increase.
o In a situation of full employment, an increase in the money
supply causes the price level to rise.