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Theories of Money (With Approaches)

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Value of money is a term that is necessary to be understood to get acquainted with the theories of money.

In economics, different economists have defined the term value of money differently.

Some of the economists explained value of money as the value of gold and silver in terms of their weight and fineness.

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Other has defined the value of money as the value of Indian currency against foreign currencies.

On the other hand, few economists have associated the term value of money with the internal purchasing power of a nation. However, logically, value of money is associated with its purchasing power, which refers to the quantity of goods and services that can be purchased with a unit of money. The values of money and price levels in a country are inversely proportional to each other. For example, when the price level in a country is high, the value of money is low and vice-versa.

The three main approaches are used for the monetary analysis of a country, which are as follows:

a. Quantity Velocity Approach/Cash Transaction Approach/Freidman’s Restatement

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b. Cash Balances Approach

c. Income-Expenditure Approach

Among these three approaches, quantity velocity approach and cash balances approach are grouped under quantity theories of money. On the other hand, the income-expenditure approach is the modern theory of money. Let us discuss these theories of money in detail.

a. Quantity Velocity Approach:

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Till now, the economists believed that the price level show changes because of the changes in quantity (demand and supply) of money. However, in the present scenario, most of the economists have believed that quantity theory of money is not applicable in practical situations. Quantity of money comprises cash (M) and its velocity (V).

The velocity of circulation of cash depends on various factors, such as frequency of transactions, trade volume, type of business conditions, price levels, and borrowing and lending policies. According to the quantity theory of money, the changes in price level of a country occur due to changes in the quantity of money in circulation, while keeping other factors at constant. In other words, an increase or decrease in the price level would occur due to increase or decrease in the quantity of money.

Therefore, it can be concluded that price level and quantity of money are directly proportional to each other. However, in extreme conditions, an increase in the quantity of money would lead to a proportional decrease in the value of money, while keeping other factors at constant and vice versa.

In the quantity theory, the other factors that are kept constant are as follows:

(a) Velocity of circulation of money:

Refers to the frequency at which a single money unit flows from one individual to another. For example, if a ten-rupee note circulates through 10 individuals, then the quantity of money would be 100, but not 10.

(b) Credit instruments:

Help in increasing the quantity of money. An increase in the use of credit instruments, such as bank cheques and book credit, would lead to an increase in the quantity of money.

(c) Barter system:

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Involves transactions that take place without the use of money. Such transactions are either discarded or considered to increase the quantity of money.

(d) Volume of transactions:

Requires to be constant. Volume of transactions refers not only to the amount of goods and services exchanged, but the number of times money changes hand.

Prof. Irvin Fisher has provided a formula for explaining the relationship between quantity of money and its value, which is as follows:

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P = MV + M’V’/T

Where, P = Price level/Value of money

M = Metallic money

M’ = Credit money

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V = Velocity of metallic money

V = Velocity of credit money

T = Transactions performed by money

In the preceding formula, the supply and demand of money becomes equal. When the price level is multiplied by the transactions performed by money, it provides the total value of transactions (PT). It is also termed as the demand for money. PT is equal to the supply of money as it includes cash and credit instruments along with their velocities (MV + M’V’), which is described as follows:

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PT= MV + M’V’

MV + M’V’/T

According to Fisher, in short-run, the values of T, V, and V remain constant. In addition, the proportional change between M’ and M also remains constant. Therefore, P and M are directly proportional to each other. In other words, the value of money (I/P) is inversely proportional to quantity of money (M).

The other factors remain same due to various reasons. Prof. Fisher has explained that in short run, there are no or negligible changes in the economic factors, such as population, consumption, production, production techniques, technology, customer’s tastes and preferences, and circulation of money.

Therefore, the demand for money is constant in short run. With respect to the supply of money, the circulation of money and credit is dependent on the habit of people. The proportional change between M’ and M depends on bank policies. Therefore, these factors also remain constant in short-run.

The quantity theory is criticized on a large scale due to its static nature. In quantity theory, most of the factors remain constant, which is not true as real world conditions are dynamic in nature. Therefore, all the factors in this dynamic world keep on changing with time.

In short-run, factors, such a population, frequency of transactions, and velocity of circulation, change either at a low rate or at high rate, but show changes. Therefore, apart from the quantity of money, other factors may also produce changes in level of price and consequently in the value of money.

For example, change in trade volume, better transport facilities, and increase in credit facilities would also bring a change in the level of price. In addition, the quantity theory has not explained the process by which the change in quantity of money produces change in the price level. The theory also considers that money is only used for the transaction purposes. However, it can also be held by individuals as idle cash and savings.

Apart from this, other factors, such as M, V, M’, and V’, are not independent factors. Among these factors, one factor can easily bring changes in other factors. For example, change in M can produce changes in V, which further make changes in the value of P.

b. Cash Balances Approach/Cambridge Equation:

Cash balances approach is the modification of quantity velocity approach and is widely accepted in Europe. This approach is based on national income approach and considers the concept of liquidity. According to cash balances approach, the value of money depends on the demand and supply of cash balances for a given period of time. The demand for money is not only dependent on the quantity of goods and services that would be exchanged, but also on the time period at which the transaction takes place.

For example, an individual would not purchase food grains for the whole year at once, but he/she would purchase on monthly basis. Therefore, he/she is required to hold enough cash with him/her to buy food grains and other products from month after month.

Thus, if in an economy individuals are habitual for holding money for overcoming their expenditure for a longer period of time, then the demand for money would be more. In such a case, only a small part of income is held by individuals and rest of the amount is invested.

This is because holding a large amount of cash as idle cash would be a loss or danger for the individual On the other hand, cash balances held by individuals should also not be very low, so that contingencies cannot be overcome.

According to Marshall, “A man fixes the appropriate fraction (of his income) after balancing one against another the advantages of a further ready command and the disadvantages of putting more of his resources into a form in which they yield him no direct income or other benefit.”

Therefore, an individual should hold a particular amount of cash with him/her to fulfill his/her needs as well as overcome uncertainties. Let us express the fraction of income that should be held by individuals ask.

Now, the equation usually used is as follows:

M = kpR

Where, M = quantity of money

R = real national income (total of final goods and services that are directly consumed)

P = average price-level of real national income (average of price of clothes, food, shelter, and services)

pR represents the monetary national income. Now, a proportion of the monetary national income is held in liquid form by individuals in an economy. In addition, it also expresses the desire of individuals in an economy to have liquid cash that is termed as liquidity for buying.

If the circulation of money takes place only once, the amount of money required would be equal to the monetary national income. However, if circulation of money takes place twice, then only half pR is required for buying national product.

c. Income-Expenditure Approach:

The income-expenditure approach is given by Keynes. It is also termed as the modern theory of money. Keynes was agreed with the concept that changes in quantity of money produces changes in the price levels, as given in the quantity theory of money.

However, he did not agree with the view that determining relationship between quantity of money and price level is as easy as demonstrated by quantity theory.

According to the modern theory of money, changes in price level are brought by the changes in national income rather than quantity of money. The main reason for the change in the price level is the changes that occur in the aggregate income or expenditure. Therefore, change in quantity of money can only bring changes in the price level when it can change the aggregate expenditure with respect to the supply of output.

If there is no rise in the expenditure, then the demand for goods would not rise and consequently, the price level would not increase. In case, the expenditure rises but the supply of output is fairly elastic, then also the price level would not rise.

Therefore, the impact of change in quantity of money would depend on the following factors:

a. Effect of change in money supply on level of aggregate expenditure and volume of production

b. Type of relation between aggregate expenditure and volume of production

The amount of expenditure depends on the consumption function, investment demand schedule, liquidity preference schedule, and supply of money. An increase in the quantity of money would decrease the rate of interest. However, in case the rate of interest is very low, then the increase in quantity of money would not be able to reduce rate of interest further.

The reduced rate of interest would help in increasing the rate of investment by individuals, which would further result in increase in income. The increase in income would increase the aggregate expenditure of a nation. However, when the increased quantity of money is not able to reduce the rate of interest as it is already very low, the investment would not show any increase.

Thus, the income and aggregate expenditure would simultaneously fail to show any type of increase. In such a case, the price level would not rise even with the rise of quantity of money. However, it is also not guaranteed that if the increase in quantity of money reduces the rate of interest, then price level would rise or not.

This is because it may be possible that the proportional increase in price level is very less as compared to increase in money supply. Therefore, it is hard to determine relationship between changes in money supply and changes in price level. This is because they are indirectly related to each other and depend on aggregate expenditure and elasticity of supply of output.

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