Why Regulate The Money Supply

WHY REGULATE THE MONEY SUPPLY - Money is an item that is generally accepted as a payment for goods or services and for the repayment of debts. -It is the means by which transactions and valuation of economic assets are made. -Money makes possible the valuation of the work that people do for which they receive income. -Money helps facilitate transactions of buying and selling on cash or on credit within the economy. - It is therefore important to the smooth functioning of the economy.

Monetary Theory - Explains the role of money in the economic system. It is evident that money – in its various uses – affects production, distribution and consumption of goods and services. - With the existence of monetary theory, the workings of economic system are better understood.

• An economic system is the structure of production, allocation of economic inputs, distribution of economic outputs, and consumption of goods and services in an economy. • It is a set of institutions and their social relations. Alternatively, it is the set of principles by which problems of economics are addressed, such as the economic problem of scarcity through allocation of finite productive resources.[1 • An economic system is composed of people and institutions, including their relationships to productive resources, such as through the convention of property. • Examples of contemporary economic systems include capitalist systems, socialist systems, and mixed economies. "Economic systems" is the economics category that includes the study of respective systems.

1.Why do prices increase?

2. Why does production decline? These are very familiar economic problems whose causes are clearly related to the use of money. Monetary theory is simply the theory of the value of money.

THREE THEORIES WHICH EXPLAIN THE CHANGES IN THE VALUE OF MONEY:

1. Transaction Theory 2. Cash-balance Theory 3. Income Theory  The first two theories stress the value of money as the main determinant of economic activities while the income theory emphasizes the flow or use of money – and not its value – which causes changes in economic activities.

The Transaction Theory – state that the value of money (like goods and services) is determined by demand and supply in a given time. The three determinant of the value of money are the average quantity of money available, its average velocity, and the volume of trade. If there is an increase in the supply of money without a change in the demand of money, its value falls. This means there is an increase in price. On the other hand, if there is an increase in the demand for money without a change in the supply of money, its value rises or price level goes down.

Therefore, in general price level varies in direct proportion to the supply of money, and in inverse proportion to the demand for money. Transaction equation of exchange: PT=MV P – is the general price level or average price level paid for goods like rice, shoes, lumber, etc. M – is the average quantity of money available throughout a year or other period of time. V – is the average velocity of money in the same period or the number of times is spent in one year. T – is the volume of trade, number of transactions or total number of goods, services, and financial instruments that are brought in the market in a given period. Hence, MV constitute the supply of money and T represent the demand for money. To determine the price level, we have to transpose the equation of exchange PT=MV.

P=

MV T

The supply of money (MV) is the numerator and the demand for money (T) is the denominator. If the supply of money increase without change in the demand for money, then the price level (P) also increases. But if the demand for money increases without change in the money supply, then the price level decreases in inverse proportion. Assuming that M=1,000,000; V=18; and T=12,000,000 – what will be the P? P=MV/T = 1,000,000 (18) 12,000,000 = 18,000,000 12,000,000 = 1.50

Thus, the equation MV=PT will be: 1,000,000 (18) = 1.50 (12,000,00) 18,000,000 = 18,000,000 Now, considering the original assumption, what will be P, if there is a change on either of the following (other factors remaining the same or constant): 1. M is increased by 200,000 - P is 1.80 2. V is increased by 6 P is 2.00 3. T is decreased by 2,000,000 P is 1.80 4. M is decreased by 300,000 P is 1.05 5. V is decreased by 6 P is 1.00 6. T is increased by 6,000,000 P is 1.00

The resulting figures are indicative of the fact that prices will rise if there is a corresponding increase in M or V or decrease in T. On the other hand, prices will fall if there is a corresponding decrease in M or V or increase T. In a nutshell, the transactions equation explains the interdependencies existing among the quantity of money, its velocity (rapidity), the quantity of transactions and the level of prices over a period of time.

CASH –BALANCE THEORY • Both the cash-balance and transaction theories determine the value of money through the demand and supply relationships. • The supply of money in the cash-balance theory refers to the cash-balances or money holdings of the people, not the velocity of money as recognized by the transaction theory. • People like to hold cash (liquidity preference) for transactions, precautionary or speculative motives. We like to retain a cash-balance to be able to buy goods and services in the future to be able to meet unexpected expenses like accidents or sickness.

 Business corporations, on the other hand,

maintain cash-balances for financial stability or future investments. The decision to hold such cash-balances depends on the economic conditions of the individuals and corporations. For instance, a person with a good and regular income has lesser need for cash-balance. A new business firm has to retain bigger cash-balance to be able to meet its daily financial transactions and pay for the salaries of its workers.

Cash-Balance Equation of Exchange: M=KTP M – is the average quantity of money available. K – is the proportion of the year’s volume of trade over which the people decide to retain their purchasing power in terms of cash balances. T – is the volume of trade, or total quantity of goods, services, and property rights that are bought in a given period of time. P – is the average of the price of goods, services and property rights.

Thus, KT is the demand for money and M is the supply of money.

* The cash-balance equation simply states that the purchasing power of the available money in the form of cash balance is equal to the value of the commodities, services and property rights. Assuming that M=1,000,000; K=1/6; & T=12,000,000 what will be P?

P=M/KT = 1,000,000 1/6 (12,000,000) = 1,000,000 2,000,000 = 0.50 Now, reverting to the original assumption, what will be P, if there is a change on either (or both) of the following (other factors remaining the same or constant): 1. K is increased from 1/6 to 1/3 2. T is increased from 12,000,000 to 15,000,000 3. K is decreased from 1/6 to 1/24 4. T is decreased from 12,000,000 to 6,000,000 Answers: 0.25, 0.40, 2.00 & 1.00. * Cash-balance equation relate the dependencies among the supply of money, the quantity of money, and the demand for money at a given point of time.

Income Theory – maintains that changes in the economy are not influenced by the changes in the value of money or price levels. *