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QUANTITY THEORY OF MONEY It is a theory about how much money supply is needed to enable the economy to function. It states that the demand for money is simply for spending on foreseeable transactions. L A W: Other things remaining the same, if the quantity of money is doubled, prices would be doubled, thus the value of money would be halved. The identity (equation of Exchange) of Quantity Theory of Money is: LIMITATIONS: 1. If V is constant, any growth in M to increase output T would result in inflation. 2. T is given because it is assumed that there is always full employment in the economy. 3. If T is growing, V is constant, then matching growth in M is needed to avoid deflation. Monetarists argue that an increase in Money supply will lead directly and quickly to changes in NI and PI, V b Where P = Price level of goods bought and sold; T = Number of Transactions; M = Money supply; and V = Velocity of Circulation. Velocity of Circulation in Pakistan: VP k = GNPMP (PT) / Average Money Stock for the Quarter (M) ASSUMPTIONS: 1. It is assumed that M is both the quantity of Money demanded and quantity of Money supplied. 2. V has a roughly constant value. 3. T is either given or it is independent of the amount of money. 4. The amount of M is determined by the other factors and is independent of V, T or (most significantly P). In this way Quantity Theory of Money becomes the Theory of Price Levels. Because since PT=MV, therefore P=MV/T where V, T = constant. P will vary directly with M i.e. if M changes Price also changes so inflation would be directly related to supply. _________________________________________________________________________________________ Visit: http://rehanaca.space.live.com for more free stuff! For Queries and Suggestions: [email protected] or [email protected] NEW QUANTITY THEORY OF MONEY Friedman restates the quantity theory of money and argued that money is just one of five broad ways of holding wealth. The five ways are: i. Money; ii. Bonds; iii. Equities; iv. Physical goods; and v. Human wealth. Each of the above gives some kind of satisfaction or yield to the holder. Friedman argued that the demand of money is related to the demand of for holding wealth in its other forms. Money is the direct substitute for wealth in the forms of bonds, equities or physical goods. Monetarists believe that people would possibly invest money to earn interest, but they might also use it instead to buy equities or physical assets. Monetarist argued that money is a temporary abode of purchasing power waiting to be spent on other types of financial or physical assets. The demand for money is therefore a function of the yield on money and the yield on other forms of holding wealth. Yield here includes non-monetary yields. Monetarists argue further that the demand for money is fairly interest-inelastic. The demand for money is related to transaction motive, but not to any speculative motive. An expected rise in the interest rates might persuade individuals to sell bonds and buy other assets, but not to hold speculative money. Monetarists hold the view that the reason for demanding money is for transactions only, not speculation about future investment. Monetarists argue instead that interest rates are determined by the demand and supply of Loanable Funds. An increase in the Ms, without any increase in demand for Money, will increase the amount of Loanable funds available. Interest rates will fall, and investment will rise. TRANSMISSION MECHANISM The mechanism by which changes in demand for and supply of money affects AD is called Transmission Mechanism. It describes the process whereby any excess of money demanded over money supplied, or vice versa causes a change in the Aggregate expenditure in the economy (i.e. change in NI). The Transmission Mechanism operates in three stages: i. The link between monetary equilibrium (Ms = Md) and the interest rates. ii. The link between the interest rate and Investment Expenditure. iii. The link between Investment Expenditure and Aggregate Demand. CONCLUSION: For Monetarists, changes in the Ms cause changes in the money value of NI. _________________________________________________________________________________________ Visit: http://rehanaca.space.live.com for more free stuff! For Queries and Suggestions: [email protected] or [email protected]