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.
Six Qualities (characteristics) of Money
1. Portability: can be carried around easily (in wallet or
pocket)
2. Durability: must be able to stand the test of time
without disintegrating
3. Divisibility: be able to divide into smaller units to
enable a wide range of transactions e.g. $1 =
100cents.
4. Recognisability: not easily copied (forged)
Recongnisiblity
Qualities (characteristics) of Money
5. Acceptability: the legal status of money is given as
legal tender by government
6. 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)
Money Supply
 RBNZ ( Reserve Bank of NZ) – Established in 1934 and is given the
sole right to issue notes and coins.
 M1 = notes and coins held by public plus transaction account
balances held at banks.
 M2= M1 + on call funds at registered banks. E.g. Savings accounts
(usually have to go to the bank to acquire these funds)
 M3 = M2 + term deposits at banks and other financial institutions.
The quantity theory of money
 An economic model used to show the link between
the amount of money circulating in an economy and
price (inflation)
Assume the
economy only has
households and
producers
Example
There are only four
crates of goods
produced in this
economy
Income
Spending on Goods
and services
We are imagining that the money stock = 100 (M)
So workers must have been paid $100 (Income)
The goods that they bought were also worth $100 (Spending) – Four crates ($25
each)
Money has circulated ONCE in the year. From firms to households then from
households to firms.
So Money stock = Price of each good x quantity of goods (Q)
M=Q
Money will circulate
more than once a
year.
Example two
Imagine money
circulates four times
in a year.
Each time the firm
pays the
households $100
for their labour and
households buy four
crates from firms.
(Total 16 crates)
So
Money stock (M) x the number of times the money circulates (v) = Price of
each good (p) x the number of goods Q
100 x 4 = 25 x 16
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
- most common theory
 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.
 MV=PQ
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.
MV=PQ
Increases
by 15%
Increases
by 15%
Quantity Constant?
It is clear, real output, can change over time. This means that the assumption
that Q is constant is a weakness – This leads us to the Sophisticated
Quantity Theory of Money.
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).
Work Book page 15 – 16
19-20
THE BUSINESS CYCLE
PEAK/
BOOM
Economic
activity
% Change
in RGDP
PEAK/
BOOM
TROUGH/
Recession
TROUGH/
Recession
Time
The Business Cycle
 Peak / upswing –





High Economic Activity
Low unemployment
High Investment
Consumer and business confidence is high.
High Inflationary Pressure
 Downturn/Recession






Reduced economic activity
High Unemployment
Reduced investment
Unemployment increasing
Consumer and business confidence is low
Disinflation or deflation occurring
 When an economy is operating near its full capacity, all
resources and technology are being fully utilised and
output is unlikely to be able to increase to help offset the
increase in money stock. The economy lacks spare
resources required to produce the extra output. So real
output cannot increase when money stock is increased.
This means the price level (inflation) will increase.
Economic
activity
Near full
Capacity
Time
 If the economy is not near full utilisation, the there
are resources available to be used to produce more
output. If the economy is not near full capacity then
there are resources ( Capital and Labour) available to
be used to produce more output. It is possible for an
increase in the money stock to be absorbed by
increases in output, meaning inflation is less likely to
occur.
Economic
activity
Not near full capacity
Time
 Recession = When Real GDP falls for two successive
quarters
 Depression = a very severe recession
Work book page 43-44