University Name: Jamhuriya University

Faculty Name: Economics and Management Science

Department Name: Banking and Finance

Class Name: BF201

Subject Name: The Economics of Money, Banking and Financial Markets

Lecturer Name: Mohamed Abdi Elmi

Assignment Name: Quantity Theory of Money

Deadline day: 13/12/2022

Names ID Number

1. A/lahi Hussein Mohamed B420031

2. Nur Hussein Adan B420051

3. Hodan Nur Abdi B420014

4. Naemo Ahmed Hashi B420054

5. Mohamed Ahmed Mohamud B420049

1.1 How economists continue to study the link between changes in the money supply and

changes in the price level

Monetary economics is a branch of economics that studies different theories of money. One of

the primary research areas for this branch of economics is the quantity theory of money (QTM).

Quantity theory of money states that money supply and price level in an economy are in direct

proportion to one another. When there is a change in the supply of money, there is a proportional

change in the price level and vice-versa.

According to the quantity theory of money, if the amount of money in an economy doubles, all

else equal, price levels will also double. This means that the consumer will pay twice as much

for the same amount of goods and services. This increase in price levels will eventually result in

a rising inflation level; inflation is a measure of the rate of rising prices of goods and services in

an economy.

As a result of colonization, the quantity theory of money was developed in the 16th century

following the influx of the gold and silver from the Americas into Europe.

The development led economist Henry Thornton in 1802 to assume that more money equals

more inflation and that an increase in money supply does not necessarily mean an increase in

economic output.

The Nobel prize winning economist, Milton Friedman, restated this theory and famously said

that ‘inflation is always and everywhere a monetary phenomenon’ (Friedman and Schwartz,

2008). When a country experiences a high inflation, the money supply in that country would also

be higher.
Irving Fisher formulated the famous equation for the quantity theory of money: MV=PY. There

is a direct relationship between the money supply in the economy and the level of prices of

goods and services sold. If we increase the money supply in the left-hand side of the equation,

the average price level will increase at the similar pace, which we can observe clearly from the

market condition. (Changes in the quantity of money lead to proportional changes in the price

level.) This is the phenomenon of too much money chasing too few goods. This formula of

quantity theory of money makes the direct relationship between money supply and price level

evident.

1.2 inflation, Hyperinflation, causes of hyperinflation, and Hazards of hyperinflation

What is Inflation?

In a market economy, prices for goods and services can always change. Some prices rise; some

prices fall. Inflation is a continual increase in the price level, affects individuals, businesses, and

the government. In other words, inflation reduces the value of the currency over time. It means,

you can buy less for $1 today than you could yesterday.

The causes for inflation in the short term and medium term remain a contested issue among

economists all over the world. However, there is a consensus that, in the long term, inflation is

caused by changes in the money supply. As we know, the price level (inflation) and the money

supply generally rise together. These data seem to indicate that a continuing increase in the

money supply might be an important factor in causing the continuing increase in the price level

that we call inflation.

Deflation is the opposite of inflation, when consumer and asset prices decrease over time, and

purchasing power increases. you can buy more goods or services tomorrow with the same

amount of money you have today.

Hyperinflation is a term to describe rapid, excessive, and out-of-control general price increases

in an economy. hyperinflation is rapidly rising inflation, typically measuring more than 50% per

month.

Typically, hyperinflation is triggered by a very quick growth in the money supply. This could be

caused by a government printing money to pay for its spending or what’s known as demand-pull

inflation. The latter happens when a swell in demand exceeds supply, launching prices higher.

What does this mean? In short, when more money is brought into circulation, the real value of

the country’s currency can plummet. Therefore, when measured in terms of the impact on

people’s lives, hyperinflation can be devastating. Prices of ordinary and essential goods, such as

bread, coffee and tea can rise on a daily basis.

How many times has this happened before?

Although hyperinflation is a rare event for developed economies, it has occurred many times

throughout history in countries (Netherland I n 1634, Germany in 1923, Zimbabwe in 2008 and

etc.)

Causes of Hyperinflation

Hyperinflation is often associated with wars, their after-effects and other crises that make it

difficult for the government to Tax the population.

So, the government starts printing more money to finance their expenditures and thus pumps

money into the economy.

The increase in money supply is often caused by a government printing and injecting more

money into the domestic economy or to cover budget deficits. When more money is put into

circulation, the real value of the currency decreases and prices rise.

Hazards of Hyperinflation

Hyperinflation can cause several adverse consequences. People may begin hoarding goods, such

as food. In turn, there can be food supply shortages.

When prices rise excessively, money decreases in value because inflation causes it to have less

purchasing power. Less purchasing power means consumers spend more to buy less. As a result,

they have less money to pay bills and fewer dollars to use on essential items.

Also, people might not deposit their money in financial institutions, leading banks and lenders to

go out of business. Tax revenues may also fall if consumers and businesses can't pay, resulting in

governments failing to provide essential services.

1.3 Irving Fisher’s equation of exchange

The transactions version of the quantity theory of money was provided by the American

economist Irving Fisher in his book- The Purchasing Power of Money (1911).

Irving Fisher’s equation of exchange is

PxY=MxV
The relationship between Money supply and Prices

Irving Fisher used the equation of exchange to develop the classical quantity theory of money,

i.e., a causal relationship between the money supply and the price level.

According to Fisher, “Other things remaining unchanged, as the quantity of money in

circulation increases, the price level also increases in direct proportion and the value of

money decreases and vice versa”.

we can write the price level as follows:

Example, if aggregate output is $10 trillion, velocity is 5, and the money supply is $2 trillion,

then the price level equals 1.0.

P = $2 trillion x 5 /$10 trillion= 1.0

If M doubles, P must also double in the short run because V and Y are constant.

Example, if aggregate output is $10 trillion, velocity is 5, and the money supply is $4 trillion,

then the price level equals 2.0.

P = $4 trillion x 5 /$10 trillion= 2.0

The relationship between Money supply and inflation

According to Fisher equation there is relationship between Money supply and inflation that is if

the money supply rises faster than real output, then the price will usually rise.
We now transform the quantity theory of money into a theory of inflation. You might recall from

high school the mathematical fact that the percentage change (%∆) of a product of two variables

(Product Rule) is approximately equal to the sum of the percentage changes of the individual

variables. In other words,

Product Rule

Percentage change in (x) (y) = (percentage change in x) + (percentage change in y)

Using this mathematical fact, we can rewrite this equation of exchange (P x Y = M x V) as

follows:

%∆P + %∆Y = %∆M + %∆V

Subtracting %∆Y from both sides of the preceding equation, and recognizing that the inflation

rate π is equal to the growth rate of the price level %∆P, we can write:

π = %∆P = %∆M + %∆V - %∆Y

Since we assume velocity is constant, its growth rate is zero, and so the quantity theory of money

is also a theory of inflation:

π = %∆M - %∆Y

Because the percentage change in a variable at an annual rate is the same as the growth rate of

that variable, The Equation can be stated in words as follows: The quantity theory of inflation

indicates that the inflation rate equals the growth rate of the money supply minus the

growth rate of aggregate output.

For example, if the aggregate output is growing y at 3% per year and the growth rate of money m

is 5%, then inflation is 2% (= 5% - 3%).

If the Federal Reserve increases the money growth rate m to 10%, then the quantity theory of

inflation given by the Equation indicates that the inflation rate will rise to 7% (= 10% - 3%).

1.4 The Evolution of money and the payment system

As we know money has played a pivotal role in the development of human civilization and

economies. The evolution of money has brought us to where we are today. Money can be in the

forms of paper money and coins and also in intangible forms such as digital money.

But how did we get here? What really is money, and what are its functions and characteristics?

What were the different forms of money throughout human history? These are all questions that

come to mind when trying to understand the evolution of money. Get ready to learn more about

one of your, my, and possibly, everyone else's favorite, money, but in particular, the evolution of

money.

The Evolution of Money

Economists define money (also referred to as the money supply) as anything that is generally

accepted as payment for goods or services or in the repayment of debts. The Evolution of

money is a series of development in the form of the acceptable medium of exchange throughout

history.

But why is money so important?

Money is important because it allows us to obtain the things we need and want. It is a crucial

element for individuals in an economy as it is the gateway for individuals to attain utility

- receiving satisfaction from the consumption of goods and services. Money is an agreed-upon

form of payment that is used for the purchase and sale of goods and services and can also be

used for lending and repayment of loans.

You are familiar with the paper money that we use in everyday life today, but money has not

always existed in this form. There have been different forms of money throughout human history

that played the role of facilitating economic transactions. This is what we mean by the evolution

of money.

Stages of the Evolution of Money

The stages of the evolution of money include different forms of money throughout time. The

origin of money was in tangible forms, and in recent years can also be found in intangible forms.

Over time, as economies grew, it was evident that certain practices such as commodity money

are not so efficient for conducting transactions. Other forms of money became more appealing as

they not only satisfied the requirement for a medium of exchange but also helped the economy

grow.

Evolution of the payments system is the method of conducting transactions in the economy.

The payments system has been evolving over centuries, and with it the form of money.

There are different ways of payment system such as:

 Barter trade

 Commodity money

 Fiat money
  Digital money

 Crypto-currency especially Bitcoin

Barter trade

Barter is a system of exchange in which individuals trade goods and services directly for other

goods and services. Barter exchanges prevailed in the early stages of development in our

economy, but they were inefficient. An example of a barter exchange would be a farmer who

specializes in growing fruits trading with another farmer who specializes in growing grains. The

two farmers would come to an agreement on how much fruit to trade for grains to meet their

individual needs. It was hard for trade to happen, as it would require both sides to want exactly

what the other person had to offer.

There are four main sources of inefficiency in a barter economy:

1. A double coincidence of wants increases the transactions costs.

2. Each good has many prices.

3. A lack of standardization exists for goods and services.

4. It is difficult to accumulate wealth.

Commodity Money

To obtain perspective on where the payments system is heading, it’s worth exploring how it has

evolved. For any object to function as money, it must be universally acceptable; everyone must

be willing to take it in payment for goods and services.

Commodity money is a good used as money that also has value independent of its use as

money. It is valuable, easily standardized and divisible commodities (e.g., precious metals,
cigarettes). From ancient times until several hundred years ago, commodity money functioned as

the medium of exchange in all but the most primitive societies. Examples of commodity money

throughout history included cocoa beans, tea, tobacco, salt, and seashells

The problem with a payments system based exclusively on precious metals is that such a form of

money is very heavy and is hard to transport from one place to another. Imagine the holes you

had wear in your pockets if you had to buy things only with coins! Indeed, for a large purchase

such as a house, you’d have to rent a truck to transport the money payment.

Fiat Money

Fiat money has no value apart from its use as money, e.g., paper currency. The next

development in the payments system was paper currency (pieces of paper that function as a

medium of exchange).

Initially, paper currency carried a guarantee that it was convertible into coins or into a fixed

quantity of precious metal. However, currency has evolved into fiat money, paper currency

decreed by governments as legal tender (is the government designation that currency is accepted

for payment of taxes and people must accept it in payment of debts.) but not convertible into

coins or precious metal.

Paper currency has the advantage of being much lighter than coins or precious metal, but it can

be accepted as a medium of exchange.

Major drawbacks of paper currency and coins are that they are easily stolen and can be expensive

to transport in large amounts because of their bulk. To combat this problem, another step in the
evolution of the payments system occurred with the development of modern banking: the

invention of digital money.

Digital money

Digital money (or digital currency) refers to any means of payment that exists in a purely

electronic form. Digital money is not physically tangible like a dollar bill or a coin. It is

accounted for and transferred using online systems. One well-known form of digital money is

the cryptocurrency Bitcoin. There are other examples of digital money such as Electronic

Payment, and E-money.

Electronic money is money that is stored electronically and can be accessed through devices to

complete transactions. Electronic money is money that exists in banking computer systems and is

available for transactions through electronic systems.

Crypto-currency especially Bitcoin

Bitcoin is a digital currency -- also called cryptocurrency -- that can be traded for goods

or services with vendors that accept Bitcoin as payment. Bitcoin was introduced to the public in

2009 by an anonymous developer or group of developers using the name Satoshi Nakamoto. t

has since become the most well-known cryptocurrency in the world. Its popularity has inspired

the development of many other cryptocurrencies.

Although Bitcoin functions as a medium of exchange it is unlikely to become the money of the

future because it performs less well as a unit of account and a store of value.