Chapter 4

THE VALUE OF MONEY

 INTRODUCTION
• Role of money is to facilitate exchange.
• Money is considered medium; it has value.
• Value of money has significant role in economic and economic
problems.
• Money is not used for its own sake, but for the goods and services
purchased.
“value of money is meant its purchasing power- its capacity to
command goods in exchange for itself”.
“ if money buys more commodities than it did at sometimes, then value
of money is high. If it buys less , then value of money is low”.
• The real value of unit of money at a given time and place is the
quantity of goods and services of all kinds that can be purchased with
a unit of money.
Continued…..
• The value of money varies inversely with the general level of price.
• When the general prices increases the value of money falls. When the
general price decreases the value of money rises.
• In mathematical terms the value of money and general level of prices
are reciprocal to each other.

• Example: if value of money falls by 10%, there is rise of 10% in

the general price level.

• Similarly, a rise of 10% in the value for purchasing power of

money is the same decline of 10% in general price level. (the above
forces are important to understand to understand role and functions
of economics).
QUANTITY THEORY OF MONEY: FISHER’S TRANSACTION APPROACH
• Ivory Fisher , an American economist: Cash Transaction Approach for
quantity theory of money.
• Book “ PURCHASING POWER OF MONEY” 1911.
• Stated that the value of money in a given period of time depends upon
the quantity of money circulation in the economy.
• It is the quantity of money which determines the general price level and
the value of money.
• Any change in money supply directly affects the general price level and
value of money. Inversely in same proportion.
• According to Fisher’s “ other things remain remaining unchanged, as
quantity of money circulation increases, the price level also increases in
direct proportion and the value of money of decreases and vice versa.
Continued……

• If the quantity of money in circulation is doubled, the other

things being equal, the general price level will be doubled
and the value of money is halved. Similarly if the quantity of
money is halved, the price level will be halved and value of
money doubled.

• The Fisher’s cash transaction version of money, the general

price level in a country, like the commodities is determined
by supply and demand for money.
 Supply of Money

• The supply of money consist of quantity of money in

circulation (M), the velocity of its circulation (V) i.e. the
number of times the money changes hands. Thus (MV) refers
to total volume of money in circulation during period of time.

• Example if total money supply in Pakistan is Rs 5000 billion.

• The velocity per unit of time is 10 times. 5000(10)= 50,000
billion.
 Demand of Money
• People demand money not for its own sake. They demand money because it serves a medium of
exchange.
• The money is used to carry every day transaction.
• Equation of Exchange:
P= MV+ M1V1/ T OR PT= MV+ M1V1
P = is the price level
M = is the quantity of money
V= is the velocity of circulation of M
M1= is the volume of credit money
V1 = is the velocity of circulation of M1
• T= total volume of goods and trade.

• M = Rs 2000,
• M1 = Rs 1000,
• V = 6,
• V1 = 4
• T = 8000 goods
Continued……
P = (2000 x 6) + (1000 x 4)/ 8000
P = 12000 + 4000/8000
P = 16000/ 8000
P = Rs 2 per good

IF THE MONEY SUPPLY IS DOUBLED

P = (4000 X6) + (2000 X 4)/ 8000
P = 24000+ 8000/8000
P = 4 Per Good
Quantity of money figure 4.1 (a)
Quantity of money figure 4.1 (b)
 Quantity of money figure 4.1 (b)
• 4.1 (a) it is shown that when the supply of money is increased from
QM to QM2, the price level also rises from OP1 to OP2.
• As the quality of money increases four times to QM4, the price level
also increases four times to OP4 .

• Figure 4.1 (b) the inverse relationship between quantity of money

circulation and the value of money shown.

• When the quantity of money is QM1, the value of money is VM1.

when the money supply is doubled from QM1 to QM2, the value of
money is reduced to half from VM1 to VM2
 Assumptions of the theory
Full employment: the theory is based on the assumption of full employment
in the economy.

T and V are constant: the theory assumes that volume of trade (T) in short
run remains constant. So is the case with velocity of money (V) which remains
unaffected.

Constant relation between M and M1: fisher assumes constant relation

between currency money M and credit money M1

Price level (p) is a passive factor: the price level (p) is inactive or passive in
the equation. P is affected by other factors in equation. i.e., T, M, M1 and V1
but it does not affect them.
 Criticism of the theory
Unrealistic assumption: in this theory P is considered a passive factor. T is independent M1, V,
V1 are constant in short run. All these assumption are covered under “ other things reaming
same”. In actual working of the economy these factors do not remain constant. Hence theory is
misleading.
Various variable in the transaction are not independent: the various variables in transaction
equation are not independent as assumed in the theory. In fact they influence very much each
other.
Assumption of full employment is wrong: Keynes has raised an objection that assumption of
full employment is a rare phenomena in the economy and the theory is not real.
Rate of interest is ignored: the influence of the rate of interest on the money supply and the
level of prices has been completely ignored. An increase or decrease in money supply has
important bearing interest rate. An increase in money supply leads to a decline in the rate of
interest and vice versa.
Fails to explain trade cycles: the theory fails to explain trade cycle. It does not tell as to why
during depression, the increase in money supply has little impact on price level.
Ignores other factors: there are many factors such as M, V, and T have other implication on
price level. The factors such as income, expenditure, saving, investment, population
consumption have been ignored from the theory.
 Cash Balance Approach to the Quality Theory
of Money

• Cash balance approach to quantity theory was developed by Cambridge economists in

England, Alfred, Marshals, Pigou, Robertson, Keynes. STORE FUNCTION OF MONEY.

• This theory is different from Fisher’s theory.

• Fisher’s approach was based on the MEDIUM OF EXCHANGE.

• According to cash balance theory; the value of money is determined like value of
commodity on the basis of demand and supply.

• This approach considers demand for and supply of money at a particular time RATHER
THAN OVER A PERIOD OF TIME. As considered by transaction approach.

• The supply of money is at particular time is fixed so it is the demand for money which
determines the value of money.
Continued…..

• Demand for money, according to Fisher’s approach to the quantity

theory, the demand for money is to serve a medium of exchange.
• According to Cambridge model the demand of money implies to the
DEMAND FOR CASH BALANCE .
• People keep/hold certain amount of real income in cash balance; the
money in liquid form is needed to pay for the goods and for unseen
and unexpected expenditures.
• Supply of money is fixed at particular time. Therefore, changes in
price level depends upon the changes in demand for holding money or
cash balance.
• Increase in demand of money means increase in demand for cash
balance.
 Continued……….
• When the demand for money rises, people curtail their expenditures on goods and
services.

• The decrease in demand for goods and services will bring down the price level and
raise the value of money.

• Similarly, a lesser demand for cash balances means higher demand for goods and
services which causes increase in the price level and fall in the value of money.

• According to Cambridge economist, the demand for money as a store of wealth.

Robertson called as MONEY ON THE WINGS’ is directly influenced by the level of
people’ wealth in the country.

• As the national income grows, the people’s desires to hold money in cash also rises.
 Key Cambridge Equation
Alfred Marshall’s Equation
CE explains cash balance approach to
the quantity theory of money.
The Marshall’s cash balance version Thus the price level
to the quantity theory of money P= M/KY
improved by Freidman.
If M= 1000,
M= stands for quantity of money
(currency plus demand deposits). y= 10000
P= price level K= ½ OR .5
Y= aggregates real income Then price level will be ???????
K= fraction of real income. Which 5 unit of good for per rupee.
people desire to hold in money
form.
Keynes's Equation
• n= PK OR P= n/K
P= the price level of consumption goods
n= total supply of money in circulation
k= total quantity of consumption units which people want to hold in
cash.
In above equation k is constant, a proportionate increases in n will lead
to a proportionate increases in price level (p).
If k remains unchanged, the price level will change directly in
proportion to change in n.
 Criticism for Cash Balance Approach
• Use of purchasing power for consumption of goods: the Cambridge
economists give undue importance to the purchasing power of money in
terms of consumption goods. This theory ignores speculative motive of
demand for money.
• Role of rate of interest is ignored: the cash balance theory excludes the
role of rate of interest in explaining the changes in price level. Which is
very important in influencing the demand for money.
• Unitary elasticity of demand: the Cambridge equation assumes that the
elasticity of demand is unity. It is not realistic in the dynamic society of
today.
• Real income not the determinant of K: according to CM real income
only determines the value of K i.e. the cash held by people. The fact is
that other factors such as price level, banking, business habits of people,
political conditions of country also influence on K.
Continued………
• Simple Truism: the Cambridge equation, like the FISHER’S MODEL
establishes proportionate relationship between the quantity of money
and the price level M= KPY.
The theory does not explain as how and why this relationship between
the two is established.

• K and T assumed constant: the Cambridge economist, like Fisher

also assume that K and T remain constant. This is possible in static
situation but not in dynamic condition.

• No explanation of Business cycle: the Cambridge equation does not

provide any explanation of business model.
 Modern Theory of Value of Money (Friedman)
• WEALTH THOEORY OF DEMAND FOR MONEY according to
him, money is type of durable consumer goods, held for its services
renders. OR
• Money is demanded as an assets or capital and the theory of demand
for money is a part of capital or wealth theory.
• According him assets or wealth can be hold in different forms
• Money
• Bonds
• Equities
• Physical goods
• Human capital
• The demand for money will depend upon the volume of total wealth and the
relative return on different forms of assets in which wealth can be held.
 Determinants of Demand for Money
Keynesian analysis, the demand for money is the function of level of income an the
rate of interest. According to fisher the demand for money or assets is the function
of following factors.
The rate of return on bonds: if the rate of return on bond is higher in the market.
The smaller is the demand for money and vise versa.
Rate of return on shares: higher the rate of return on equities or shares, lower is
the demand for money and vise versa.
Rate of change of prices: if the prices are rising rapidly in the country, the smaller
amount to avoid a fall in the real purchasing power of the money holdings.
Degree of risk: the degree of risk or uncertainty of an asset's return also affects the
demand for an assets. Holding other things constant. If an assets risks rises
relatively to that of an attachment assets, its quantity for money will fall down.
Liquidity: how quickly it can be converted into cash without incurring large costs.
If an assets is highly liquid relatively to an alternative assets, other things
remaining unchanged. The greater will be quantity demanded.
 Criticism of Freidman’s Theory
Influence of rate of interest ignored: Friedman's was involve in defining the various
forms of money which includes time deposit, demand deposits, and currency in
circulation. He failed to attach importance to power factor: rate of interest. Which
influence the demand for money.

Relationship between money supply and money GNP: Friedman observed that money
supply and money GNP are positively correlated with each other. Where as some
economist disagree with his view and states that there is no co relation between money
supply and money GNP. Due to number of variables which cant be kept under control.

Proportional Relationship: Friedman tested the proportion that demand for money
varies directly and proportionality to changes in the price level. The fact is that it is more
than proportionality to change in the level of income.
If we exclude time deposits from money, the income elasticity of demand will be closer
to unity.
Continued…..
Simultaneous operation of wealth and income: Friedman's function
assumes the simultaneous operation of the wealth and income variables.
Johnson disagree with this view. His opinion that income is the yield on
wealth and wealth is current income value.
The Supply and Demand for Money
Demand For Money
The Fisher Effect
The Roles Of Central Banks