Money cannot do its work efficiently if it changes in value every now and then.
How risky would the cloth business be if the length of the yardstick fluctuated while the quantity of cloth remained the same?
Changes in the value of money have got far-reaching effects both on the store of wealth and on the wealth-producing capacity of the economy. These changes arbitrarily re-arrange the purchasing power in the hands of the people who hold it.
Usually rising prices create a feeling of optimism in the early stages and all businessmen feel happy and buoyant. But rising prices hit people with fixed incomes, e.g., government servants and rent receivers. In the reverse direction, falling prices produce even more depressing and disastrous results.
A fluctuating money standard at one time checks and at another time over-stimulates the production of wealth. Many a time it results in an unbalanced growth of industry, and brings about booms or depressions. Speculation prevails and efficiency in production suffers.
Fluctuating prices create a feeling of uncertainty about the future. Transactions in future sales or purchases cannot be made with confidence, and the smooth flow of economic life is disturbed. Wealth-getting in times of inflation “degenerates into a gamble and a lottery.”— (Keynes). It is thus clear that the distribution of wealth is altered unjustly.
Effects on Different Sections:
Price level is one economic phenomenon which affects all people most vitally. But all people are not affected alike. When prices change, some people are benefited, while other suffers. Let us trace the effects of the present rise in prices on different sections of the community. The effect of a fall in the price level will be quite the opposite.
Effect on Business Community:
When prices rise, the business community, consisting of traders and manufacturers, are the gainers. They gain because their costs consisting of rent, wages, interest, etc., which are fixed by contract, do not rise, while their incomes go up as soon as the prices rise. The stocks lying in their godowns are increasing in value every day. Hence the effect of a rise in prices is to stimulate production and trade activity. But if they rise persistently and too much, as in galloping inflation, even trade and industry suffer.
Effect on Consumers:
A rise in prices is detrimental to the consumer’s interests. They have to pay more for everything that they buy. Their incomes do not go as far as they could go before. Since everybody is a consumer, a rise in prices pinches almost everybody in the community.
Effect on Workers:
The workers suffer. Their wages do not buy as much as they could buy before. It means that their real wages have gone down. Put because during the times of rising prices, there is a great trading and manufacturing activity, the workers gain in the continuity of their employment. But, on the whole, the workers suffer.
Effect on Debtors and Creditors:
When prices rise, debtors gain and creditors lose. The debtors are able to pay off their debts by parting with less quantity of commodities. The creditor, on the other hand, loses because the money that he gets back now does not buy as much as it could buy before when he gave the loan.
Effect on Fixed-incomists:
All those people suffer whose incomes are fixed. Those who live on income from rent, interest or dividends from companies, fixed salaries, pensions, etc., fall in this group.
Effects of Falling Prices:
Above, we have considered the effects of a rise in prices. If, however, the prices fall, workers, consumers, fixed-incomists and creditors will gain, while the producers and the debtors will lose.
Theories of Money and Prices:
Attempts have been made by economists to give explanation for the variations in the value of money.
Quantity Theory of Money:
There are several forces that determine the value of money and the general price level.
The general price level in a community is influenced by the following factors:
(a) The volume of trade,
(b) The quantity of currency,
(c) The volume of credit, and
(d) The velocity (or rapidity) of circulation of currency.
These four factors change independently as well as in relation to one another. Money is used in exchanging goods. The greater the volume of exchange required to be made, the greater is the demand for money, and hence the greater will be the value of one unit of money, and vice versa. Thus, the value of money varies directly with f he volume of trade.
It is well-known that the value of anything depends also on its supply. The more the wheat in a season the less its price? In the same way, the greater the number of rupees to do a given amount of money work, the less is the value of a rupee, and vice versa. In other words, the ‘value of a unit of money varies inversely with its quantity.
But we have learnt that all the money-work is not performed by cash money. A good deal of it is also done by credit money. Hence credit instruments should also be taken into consideration when we are trying to discover the total quantity of money which will influence prices in a country.
Remember, however, that money is not finished up in one use. A unit of money is ready to perform another exchange after it has served in making one. It passes from hand to hand. Thus, if a single rupee is used six times in a certain period, it does the work of six rupees if they serve only once each in the same period. Hence the number of times a rupee changes hands in, say, a year, is known as its “velocity of circulation”. Thus, the velocity of circulation of money helps the total quantity of money in determining prices.
Statement of the Theory:
The above conclusions have been put in the form of a theory called the Quantity Theory of Money. It states that the value of money depends upon its qualitative in circulation. In its most rigid form, this theory asserts that “any given percentage increase or decrease in the quantity of money will lead to the same percentage of increase or decrease in the general level of prices.”
In order to make it applicable to a modern community, the theory may be stated thus: The value of money falls (and the price level rises) proportionately with a given increase in the quantity of money. Conversely the value of money rises (and the price level falls) proportionately with a given decrease in the quantity of money, other things remaining the same.
These other things are:
(a) Velocity of circulation of money;
(b) The volume of credit;
(c) Barter; and
(d) Volume of trade.
Elasticity of Demand for Money is Unity:
The word ‘proportionately’ may be carefully noted in the above statement of the theory. Money, we know, is only a medium of exchange. It is only a counter or a ticket serving as a link in exchange and is not wanted for its own sake.
Therefore, the quantity theory concludes that if a community had twice as much money all prices would be twice as high and if it has half as much money, all prices would be half as high. The total purchasing power of all money would always be the same because “money is only important for what it will procure.”— (Keynes).
An illustration will make it clear. If in an island, one hundred articles of equal value are available for sale and there are two hundred units of money, the average price would be two units of money per article. If one fine morning, every one work up to find that the money with him had doubled itself, the average price would become four units of money per article. And if the money possessed by everybody were halved, no one would be the poorer for it, because now every coin would begin to purchase twice as much as before. In other words, the elasticity of demand for money is unity.
Demand and Supply:
We have discussed it length how the value of any commodity is settled. The words “demand” arid “supply” which would, as is humorously said, “make an economist of a parrot”, hold the key. Well, the value of money is settled in no other way. The demand for money depends upon the number of transactions, i.e., the volume of trade extent of credit and barter. The supply of money depends on its quantity multiplied by the velocity of its circulation.
Extending the general theory of value to money, we can say that if the quantity of money in circulation were increased with no change in the number of goods, its value would fall and prices rise, and vice versa.
Similarly, an increase in the amount of goods, without a change in the quantity of money, will tend to raise the value of money and lower prices.
Where Money Differs From a Commodity:
It should be noted, however, that a change in the supply of goods does not cause a proportionate change in their value. But the change in the value of money is proportionate to change in its quantity.
Equation of Exchange:
Irving Fisher, who developed the quantity theory, puts it in the form of the following algebraic equation of exchange:
P = M/T
Where P is price level, M is money and T stands for trade or goods exchanged.
This simple equation can be true only of a small isolated community:
(a) Where the number of transactions is small,
(b) Where there are no barter transactions,
(c) Where, except coins, there are no other types of money like notes and cheques in use, and
(d) Where every piece of money changes hands but once. Such isolated communities are not found nowadays, however.
We observe that, in modern communities, a coin changes hands a number of times. The butcher takes it to the baker and the baker to the grocer and he again to some other person. The work done by a coin which is circulated five times is equal to that done by five coins which change hands only once each. This speed is called the velocity of circulation. Hence to find out the effective amount of money in a country, we have to multiply the total number of coins by their velocity.
Our equation would then be:
P = MV/ T
Where V is the velocity of circulation of money. But in addition to metallic money in every modern community, there is a large amount of paper money which helps in the exchange of goods. Instruments of credit like cheques, drafts and bills also serve the same purpose. Their velocity of circulation has also to be taken into consideration.
Hence, our equation finally develops into:
P = MV+M’V’/T
Where M’ stands for credit money and V’ for its rapidity or velocity of circulation.
The equation signifies that the price level (P) changes when the quantity of money (M) or quantity of credit money (M ‘) changes or when their velocities (V & V’) change. Of course P will also change if the quantity of goods (T) required to be exchanged changes.
Criticism of the Quantity Theory:
The quantity theory has been subjected to a great deal of criticism.
In fact, modern economists do not accept it without reservations:
(i) So long as the quantity theory describes a tendency, it is all right. But when it proceeds to lay down an inflexible mathematical formula, it falls to the ground. Only under very special circumstances will a doubling of the amount of money exactly double the price level. The price level may go up to more or fall down to less than that.
(ii) A change in M (money) in reality is almost certain to cause a change in V (velocity of circulation) and T (number of transactions). A change in P (price level) also has its effects on both V and T. There is bound to be action and reaction. Therefore, the assumption that changes in M, V and T alone produce changes in P, and not on one another, does not hold good, ff that had not been so, “we could have safely predicted price changes’ and this would have served as a guide to official control of price level.”
(iii) Further, the price level does not depend on the quantity of money in circulation as such. It is influenced by income which the consumers spend in the market. During the Great Depression (1929-33), the U.S.A. created huge quantities of money to step up prices. No doubt the incomes of the people increased, but they did not spend more. That is why prices did not rise. The modern economists are, therefore, of the view that the value of money, in fact, is a consequence of the total incomes rather than that of the quantity of money.
(iv) Another criticism leveled at the theory is that it considers only the medium-of-exchange function of money and ignores its function as a store of value. But we know that people use money not only to effect transactions, i.e., as a medium of exchange, but also to hold it with them as a store of value.
(v) The value of money can change as a result of many other causes such as wars. But the quantity theory takes no notice of them. It singles out only one factor, i.e., quantity of money and holds it responsible for changes in the value of money.
Although the quantity theory is not mathematically true, yet it does lend support to the view that whenever money supply is greatly expanded, prices are bound to rise. This is what has happened in India under the Five-Year Plans. However, in view of the objections mentioned above, some of the modern economists do not subscribe to the Quantity Theory.