The Quantity Theory of Money

1. The Quantity Theory of Money Explain the concept of money, it’s functions and characteristics. Explain the theoretical link between money and prices. Explain the Quantity Theory of Money.

2. Functions of Money Medium of exchange: replacement for barter (used to purchase item instead of exchanging for another i.e. barter) Standard of value: we use money to compare the values of commodities. Store of value: for the purpose of saving (as long as we are confident that it will keep/store it’s present value and therefore retain it’s purchasing power in the future when we come to use it) Means of deferred payment: being able to borrow money and pay it back over a relatively long period of time.

3. Seven Qualities (characteristics) of Money Portability: can be carried around easily (in wallet or pocket) Durability: must be able to stand the test of time without disintegrating Divisibility: be able to divide into smaller units to enable a wide range of transactions e.g. $1 = 100cents. Recognisability: not easily copied (forged)

4. Qualities (characteristics) of Money Acceptability: the legal status of money is given as legal tender by government Relative scarcity: an increase in the money supply can lead to a fall in it’s value. People need to be confident that the value of their money will be maintained by for example the government (via controlling the amount of money circulating in the economy)

5. The Quantity Theory of Money • MV = PQ • M = the money stock • V = the velocity/speed of circulation (the number of times a unit of currency e.g. $10 note is used in a given period of time to buy G&S’s) • P = the general price level • Q = total output (GDP)

6. The Crude Quantity Theory of Money • Suggests that both V (speed of circulation) and Q (output of goods and services) are constant. • Therefore M (the money stock) is proportional to P (general price level). • Which implies that the general price level will rise with an increase in the money stock, and fall with a decrease in the money stock.

7. Example of Crude QTOM If the money supply is increased by 15% (remembering level of GDP assumed to be fixed), this will mean that there is MORE money in circulation chasing the same quantity of goods. This in turn bids up prices as the purchasing power of each dollar falls. The end result will be a proportional increase in the price level, i.e. 15% increase in P.

8. The Sophisticated Quantity Theory of Money • Assumes only V (velocity of circulation) is constant, as the output of goods and services produced can change. • Therefore if the money stock was to increase, this could lead to either a rise in the general price level (P) OR an increase in output (Q). • If the economy is operating near full capacity there will be very little room for Q to increase, therefore the P (general price level) will rise. • If the economy is operating under full capacity it has the potential to utilise idle resources to off-set inflation (rise in P).

9. The Business Cycle A business cycle is identified as a sequence of four phases: • Contraction (A slowdown in the pace of economic activity-recession phase) • Trough (The lower turning point of a business cycle, where a contraction turns into an expansion) • Expansion (A speedup in the pace of economic activity) • Peak (The upper turning of a business cycle)

10. Economic activity PEAK/BOOM Downturn/ recession TROUGH Upturn/recovery Time

11. As an economy experiences an upturn/recovery, the level of economic activity increases (i.e. unemployment falls and output rises). Resources become more fully utilised, therefore any increase in M will become MORE inflationary as Q reaches full capacity. After the peak (boom) economic activity will decline and resources become more available as output falls and unemployment rises. A rise in M could be absorbed by rises in Q rather than increasing the general price level.