Monetary theory

Monetary theory studies the influence of the demand for and supply of money upon price, interest, output and employment. There is no consensus among economist as to the proper role that money plays in the economy.

The areas of dispute are more or less theoretical and empirical in nature, most economist are of the view that the level of economic activities is a function of the supply of and demand of money but they differ with respect to the mechanism for which these changes influence the economy. One view is that interest rates affect the demand for investment goods and that this demand in turn helps determine income and employment; variations in the stock of money and in the demand for money change interest rates and thus affect income and employment.

This is referred to as the Keynesian theory. The quantity theorist on the other and accept the view that money supply and demand determine the interest rate and that in addition a change in the supply of money and in the demand for money may directly affect the demand for various forms of liquid and real wealth and hence may influence aggregate economic activities.

Quantity Monetary Theory – The Evolution And Development Of Money

The quantity theory of money or monetary theory is one of the oldest surviving economic doctrine and dates  back to back to about the mid 16th century when the French social philosopher Jean Bodin opined that the price inflation then raging in western Europe was as a result of the abundant monetary metals imported from the mines of the Spanish colonies in the south America.

In its simplest and crudest form the quantity theory holds that changes in the general level of commodity prices are determine primarily by changes in the quantity of money in circulation. This theory has undergone considerable refinement elaboration, amendment and extension in the late 17th and 18th centuries by John Locke, Richard Cantillion and David Hume. It also formed a central core of the 19th century classical monetary theory analysis and provided both the dominant conceptual framework for the interpretation of financial events in that century and the major intellectuals  foundations of orthodox policy prescriptions designed to preserve the gold standard.

Today, the quantity theory flourishes in the doctrines of the so called monetarist school that operate from such institutions as the university of Chicago and the Federal Reserve Bank of St. Louis and led by such economist as Milton Friedman Karl, Brunner, Allan Miltzor, Philip Cegan etc.

The quantity monetary theory has however not been unchallenged. As controversial as it ancient, the theory has stimulated more debate than any other single topic in the field of money theory.

What Is The Quantity Theory (Monetary theory)

Essentially, the quantity theory is a hypothesis about the main cause of changes in the value or purchasing power of money. According to the theory changes in the value of money are determined principal, by changes in the quantity circulation. When money becomes abundant, its value or purchasing power falls leading to rise in commodity prices. Conversely if money becomes scarce, its purchasing power increases and general prices fall. Thus the quantity theory states that the  stock money of money (M) is the main determinant of the price (P).

This theory as stated above consist of a set of interrelated propositions that support it. The most important of these proposition refers to

  • Proportion of M and P
  • The active or causal role of M in the monetary transmission mechanism
  • The neutrality of money
  • The monetary theory of the price level and other

The Proportionality Postulate

This states that P will vary in exact proportion to change in the quantity of M which implies that a given percentage changes in the stock of money will result in an identical change in commodity prices. This proposition follows from the assumption that people want to hold for transactions purposes a constant quantity of real (prices deflated) cash balances M/P, at the economy’s full capacity level of real output.

Because these cash holders look to the purchasing power rather than to the more money value of their cash balances, the price level must vary in direct proportion to the nominal money supply to maintain real balance intact.

Causal Role Of Monetary theory

This proportion states that the direction of causation or the channel of influences runs from M to P, in essence monetary changes precede and cause price level changes. In this cause and effect relationship money is seen as the active variable and the price level as the passive or dependant variable. The implication of this assumption of money as the active variable is that the proportionality between money and prices refers to an equilibrium condition that is established via a dynamic adjustment process, and not an identity that holds at all points in time.

The lead lag causes and effect relationship between money and prices implies that a change in M initially creates disequilibrium between M and P. This disequilibrium then involves the forces that cause P to change. Process continue to change until proportionality is restored and the disequilibrium is contained.

The adjustment process takes place through some mechanism, channel or linkage that transmits monetary impulse to the prices level traditionally; two main transmission mechanism have been identifies as;

  • Direct expenditure which describes the process by which the impact of a monetary changes is channelled to the price level via a prior effect on the demand for the goods and
  • Indirect interest are mechanism which describes the process by which a monetary change influences spending and prices indirectly via prior effect on the interest rate.

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