Transcript The Quantity Theory of Money

The Quantity Theory of Money
-Explain the concept of money, it’s functions and
characteristics.
-Explain the theoretical link between money and
prices.
-Explain the Quantity Theory of Money.
Functions of Money
 Medium of exchange: replacement for barter (used to
purchase item instead of exchanging for another i.e.
barter)
 Standard of value: we use money to compare the
values of commodities.
 Store of value: for the purpose of saving (as long as
we are confident that it will keep/store it’s present
value and therefore retain it’s purchasing power in
the future when we come to use it)
 Means of deferred payment: being able to borrow
money and pay it back over a relatively long period of
time.
Seven Qualities (characteristics) of Money
 Portability: can be carried around easily (in wallet or
pocket)
 Durability: must be able to stand the test of time without
disintegrating
 Divisibility: be able to divide into smaller units to enable a
wide range of transactions e.g. $1 = 100cents.
 Recognisability: not easily copied (forged)
Qualities (characteristics) of Money
 Acceptability: the legal status of money is given as
legal tender by government
 Relative scarcity: an increase in the money supply can
lead to a fall in it’s value. People need to be confident
that the value of their money will be maintained by
for example the government (via controlling the
amount of money circulating in the economy)
The Quantity Theory of Money
MV = PQ
 M = the money stock
 V = the velocity/speed of circulation (the number of
times a unit of currency e.g. $10 note is used in a given
period of time to buy G&S’s)
 P = the general price level
 Q = total output (GDP)
The Crude Quantity Theory of Money
 Suggests that both V (speed of circulation) and Q
(output of goods and services) are constant.
 Therefore M (the money stock) is proportional to P
(general price level).
 Which implies that the general price level will rise with
an increase in the money stock, and fall with a decrease
in the money stock.
Example of Crude QTOM
 If the money supply is increased by 15% (remembering
level of GDP assumed to be fixed), this will mean that
there is MORE money in circulation chasing the same
quantity of goods. This in turn bids up prices as the
purchasing power of each dollar falls.
 The end result will be a proportional increase in the
price level, i.e. 15% increase in P.
The Sophisticated Quantity Theory of
Money
 Assumes only V (velocity of circulation) is constant,
as the output of goods and services produced can
change.
 Therefore if the money stock was to increase, this
could lead to either a rise in the general price level (P)
OR an increase in output (Q).
 If the economy is operating near full capacity there will be
very little room for Q to increase, therefore the P (general
price level) will rise.
 If the economy is operating under full capacity it has the
potential to utilise idle resources to off-set inflation (rise in
P).
The Business Cycle
A business cycle is identified as a sequence of four
phases:
 Contraction (A slowdown in the pace of economic
activity-recession phase)
 Trough (The lower turning point of a business cycle,
where a contraction turns into an expansion)
 Expansion (A speedup in the pace of economic activity)
 Peak (The upper turning of a business cycle)
Economic
activity
PEAK/
BOOM
Downturn/
recession
TROUGH
Upturn/recovery
Time
 As an economy experiences an upturn/recovery,
the level of economic activity increases (i.e.
unemployment falls and output rises). Resources
become more fully utilised, therefore any increase
in M will become MORE inflationary as Q reaches
full capacity.
 After the peak (boom) economic activity will
decline and resources become more available as
output falls and unemployment rises. A rise in M
could be absorbed by rises in Q rather than
increasing the general price level.