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 .
 MV
P= 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.