Monetary Theory

Monetary theory explores the root economic causes shaping the demand for currency. The amount of money in circulation at any given moment, some contend, is largely determined by total spending across the economy. Because the speed at which this money changes hands rarely changes and there's a lead-time involved in more goods and services, increasing the money supply only causes inflation. Another major school of thought emphasizes individual preference in the use of money as the major determinant. Consequently, the money supply, output, prices and the rate at which money is spent can all fluctuate over time. Third theory views money as really just another commodity and demand for it is subject to supply, prices, inflation and preference for substitutes.

Keywords Equation of Exchange; Exchange Currency; Fiat Currency; Inflation; Marginal Productivity of Capital; Monetary Stock; Monetary Theory; Money Stock; Precautionary Demand for Money; Quantity Theory; Real vs. Nominal Value of Money; Specie; Speculative Demand for Money.; Transaction Demand for Money; Velocity of Money

Economics > Monetary Theory

Overview

Its symbols vary — $, £, €, ¥ — but they all identify the most useful device ever created: Money. Just how useful it is becomes painfully clear when you don't have any; then nothing else matters but acquiring some. To get anything of economic value, we must be prepared to give something of like value. In-kind exchanges of tangible goods or services involve the transfer of readily apparent value. However, barter on a large scale isn't very efficient. Bulk items are too cumbersome and the demand for most specialty items too sporadic to trade either with enough frequency to stimulate economic growth. Money solves this problem rather ingeniously: By design, it's a very portable substitute for all kinds of barter. It also assigns value. Every good and service, you see, has a particular worth relative to every other good and service. Using money as a standard unit of account permits us to represent this relative worth numerically as a price. The fact that virtually everything can be assigned a price makes money a universal medium of exchange (Zijlstra, 1979).

In all, then, money may well be the most versatile tool every invented. Its adoption and use proved instrumental to the economic specialization and division of labor that sped the production of an ever widening number of goods (Clever, 2002). Just as its concentration and use as investment capital made the industrial revolution possible. These historical facts along with money's utter centrality to modern economic life, have led economists for some time now to wonder what, if any, the exact relationship might be between the supply of available money and the amount of aggregate demand and output. Their reasoned conclusions collectively make up what's known as Monetary Theory. Arestis and Mihailov (2011) define monetary theory as “rationalizing and microfounding money itself as well as its demand by economic agents” (p. 772). On the whole, it is a fairly abstract body of work that explores a very historical phenomenon, so our surest route to understanding the essentials of the former lies in reprising the major developments of the latter first.

A Brief History of Money

For centuries, gold and silver cast along with baser metals into coins physically stored a set amount of value. Their scarcity made them 'precious' metals ideally-suited to the task, just as the widespread need for a food preservative made salt a much earlier form of 'exchange currency.' Crucially, both could be easily divided into smaller portions when the need arose. More to the point, perhaps, each was scarce and widely in demand; as such, each made for viable medium of exchange. Population growth and economic expansion, however, increases demand for currency, straining the available supply of the scarcer forms of exchange currency like gold and silver. When this happened, royal mints diluted the silver content per coin to put more in circulation. But the population's valuation of goods and services remained largely unchanged. It thus took more of the debased coins to provide the same amount of gold or silver as before, effectively driving up prices.

In the quantities needed for large transactions, what's more, silver coins were bulky and heavy; bars of gold bulkier and heavier. One way around the problem was to leave precious metals with a trustworthy party who in return would issue a certificate of ownership redeemable at anytime. The practice dates back to the goldsmiths of medieval times; the distant forerunners of today's commercial banks. Traveling merchants found they could often pay for goods with the certificates themselves. Commercial banks in the 18th century followed suite on a much wider scale, issuing promissory notes with face values redeemable by the bearer in gold or silver coins from their vaults. Bankers were pleased to discover most bearers were just as content conducting transactions solely via these notes, so banks as a rule had only to keep enough gold and silver on hand to cover a portion of the notes it had issued.

Yet, any transaction made with these notes was in the final analysis an act of faith on the part of buyer and seller. The notes themselves had to be genuine, the buyer had to have purchased them via a deposit at the issuing bank and the bank itself had to be able to convert the note into gold or silver on demand. Banks with trustworthy reputations and very large asset and customer bases helped popularize the concept of a paper currency. Over time, though, problems arose that forced changes. 'Bank notes' could be counterfeited much more easily than coinage. As much as a third of all the early bank notes circulating in the United States were forgeries. Any bank or merchant could issue its own paper currency. In fact, well over a thousand did in the United States in prior to the reforms of 1861.

With so many different sizes, colors and designs of 'bank notes' passing through their hands, it's little wonder consumers and shopkeepers alike remained skeptical about its value. The only effective way to end this chaos was to make a national government or a single bank of its choosing the sole issuer. By the second half of the 19th century, this responsibility fell to the U.S. Treasury Department, to the Bank of England, the U.K.'s largest private bank, and a semi-autonomous central bank in Japan. Each, significantly, stockpiled the necessary reserves of precious metals to redeem any bank note it issued. Other countries followed suit and, within decades, the base value of most currencies was set by assigning each an equivalent fixed weight in gold; greatly facilitating trade between nations.

Eventually, though, the amount of currency required to sustain the growing volume of cash transactions surpassed the world's stock of gold and silver. A continued preference for a commodity-backed currency was no longer economically tenable. As populations rose, a fixed money stock would invariably lead to disinflation and a reemergence of barter exchanges on a large scale and overall economic activity would suffer. The only solution lay in a 'fiat' currency. Here, essentially, the government declares a currency to be 'legal tender.' Its base value equals the amount of physical goods it can be exchanged for at the point in time when the public comes to accept and believe this assertion. From then on, monetary authorities expand or contract the money supply to maintain this common perception of its nominal value. As a medium of exchange, it works because we all willingly suspend our disbelief. In the final analysis, though, it's just paper or, in the case of demand-deposit checking accounts, entries in a bank ledger.

Insights

All monetary theory flows from two key concepts: The money stock and the velocity of money.

• The money stock is the sum of all the coin, currency and demand-deposit funds in circulation along with the vault cash held by banks and, in the last seventy-five or so years, the reserve requirements these banks must deposit with their Central Bank.
• The velocity of money is a measure of how quickly on average the money stock turns over or changes hands as transactions take place. Its inverse, 1/V, thus represents the amount of cash in circulation not spent.

Multiplying the stock of money by its velocity gives us the total value of expenditures across the entire economy. Now, crucially, the very same aggregate can also be calculated by multiplying the physical quantity of goods sold by their average price. Economists call this inherent parallelism the Equation of Exchange; it in turn gave rise to the Quantity Theory, an idea that's roots go back as far as the seventeenth and eighteenth centuries (Glasner, 2002).

The Quantity Theory

In formal terms, the Quantity Theory hypothesizes that an increase or decrease in the money stock will cause proportional increases or decreases in prices. Now this sounds like nothing more than a restatement of Quantity Equation, so why has it warranted the separate and, as we shall see, considerable attention of economists? Because of the way the terms are defined, the first is treated as a given and true in all cases: it's thus a logical expression. Proving the validity of the second essentially required a more explicit form of economic reasoning. Here, the underlying principle of market equilibrium is just as inviolate as the rules of deductive reasoning. Any proof of the Quantity Theory therefore must be derived from the basic precepts of classical macroeconomic analysis: That full employment is a condition of general equilibrium, and that, because markets compensate so quickly to any change, any disequilibrium is temporary and transitory (Handa, 2000).

It follows then that the velocity of money and the total physical amount of goods sold, outcomes associated with general equilibrium at full employment, must be independent variables. They must, what's more, remain fairly constant relative to each other. That being the case, the way is open to treat the amount of the money stock and the average price level, the other term on each side of the Equation of Exchange, as dependent variables. And since there are year-to-year fluctuations in total expenditures, finally, said treatment is reasonable and warranted. More simply put, the theory states that increasing the money supply will only end up pushing the inflation rate higher. Such at least was the seminal conclusion of Fisher's 1911 mathematical proofs establishing a formal relationship between the two dependent variables.

Monetary theorists from the 'Cambridge School' subsequently examined the role played by an individual's preference to spend or invest in this process. The more of one's resources earmarked for consumable items, the greater the demand for cash and demand deposits. Conversely, the more of one's resources put into time-deposit accounts and like financial instruments, the greater the supply. How much of each we individually elect depends on the rate of return on investment and the amount of immediate gratification the consumer in us is prepared to forgo. Critically, furthermore, since the rate of return mirrors the marginal productivity of capital, it is an independent variable much like the velocity of money is. For there to be equilibrium, then, the remaining variable on either side of the equation — the money stock and the average price level — must be dependent, rising or falling in lock-step with each other.

Keynes' Demand for Money

John Maynard Keynes, a member of the 'Cambridge School,' questioned the basic assumption underlying classical and neo-classical monetary theory. Perhaps equilibrium at full employment is not nearly as universal or as inevitable as previously thought. Indeed, the empirical evidence supporting the contrarian view that unemployment, not full employment, was frequent and systemic enough for equilibrium to be the norm. In the short-run, moreover, the velocity of money and the output of goods were not independent variables. Both could and were affected by changes in the money supply, leading Keynes to reject the Quantity Theory outright (Davidson, 1978).

Expanding on the idea that individuals made conscious choices about the types and amounts of money they hold, Keynes theorized that the demand for money arose from its actual use, the most rudimentary of which is the need to make cash purchases. This he labeled the 'transaction motive.' A second, more forward looking use was to cover unexpected expenditures. It requires that some cash be held onto as opposed to spent. Keynes called this the 'precautionary motive.' The more daring profit-seekers were recognized in his third functional category, the 'speculative motive.' Given the likelihood of a future profit, essentially, many of us will elect to invest rather than spend. The price of money, i.e. the interest rate, figures prominently in this decision: The higher the rate, the more attractive investing seems. Thus, aggregate demand for money in Keynesian economics is a composite figure, the sum of funds we pay out in transactions, the funds we keep hold of as a cash reserve and the funds we are prepared to invest given the prevailing rate of return.

Monetary Theory After Keynes

Keynes' overall approach was more descriptive than prescriptive and recognized the possibility that less quantifiable factors may influence the demand for money. It was a seminal contribution and still relevant to theorists today (Harcourt & Kriesler, 2011). However, some economists after Keynes still found aspects of the Quantity Theory appealing in principal. By scaling back some of its underlying assumptions, they believed, it might still prove a serviceable model of monetary demand. Milton Friedman led the way in this by jettisoning the ideas that prices and the money stock changed in unison. He still maintained however that the velocity of money over time changed very little if at all. Likewise, he still resolutely believed that the size of the money stock played no real role in determining aggregate output.

His ideas on the root cause of the demand for money were more original. This he likened to the demand for any other kind of consumer or capital good. And, as a commodity, it had a utility that varied in degree from one individual or firm to the next. Only the goods money acquires holds value, not money itself (Brunner & Meltzer, 1972). This in turn makes the real rather than the nominal value of money important. Inflation erodes its face value; the real harm comes from its diminished purchasing power. So, monetary demand proper, Friedman postulated, depended on the real and nominal values of current cash balances, price levels, inflation, the amount of wealth held in other assets, the yields of these other assets, and expected future earning power.

Viewpoints

Monetary theory deals in abstractions, money itself in goods and services. Using money day-in, day-out may be second-nature to us; thinking about it as a distinct economic entity is not. We all experience money changing hands but few of us assign it a rate and even fewer argue this rate is stable over time. Certainly many of us do not regularly contemplate the intrinsic worthlessness of fiat currency unless we're caught up in an inflationary spiral. Mostly, though, we tend to take money for granted; it runs through the economy much as blood flows through the body. Monetary theorists do not. To them, it's much more an observable phenomenon to be analyzed and perhaps harnessed in some way. Yet it is a subject that defies ready explanation. Theories are proposed, accepted, reevaluated, and revised or rejected. There is as of yet no one universally accepted theory that fully explains how the demand for money works.

A hundred years ago, monetary demand was pictured mechanistically. The espoused Quantity Theory seemed straightforward enough: in a full employment economy, increases in the money stock resulted in inflation, not greater economic output. But subsequent real-world events undermined the Quantity Theory's basic premise. The economic status-quo was often less than full employment. Keynes considered the reason why people used money a more pertinent theoretical spring-board and rejected the Quantity Theory. His analysis of the behavioral roots maps out a more fluid and complex process where investment plays a much bigger role than previously thought. Friedman subsequently attempted to reconcile the two opposing views and, in the process, showed how the supply and demand for money is no different than for any other commodity. Some theorists posit that the factors underlying any monetary theory are so context dependent that no one theory can be used to explain all economies (Rashid, 2012). It will be interesting, then, to see what the next great conceptual leap forward will be.

Terms & Concepts

Equation of Exchange: Since total expenditures can be expressed as the product of multiplying the money stock by the velocity and separately by multiplying total output by the average aggregate price, the two calculations are equivalent. Also called the Quantity Equation.

Exchange Currency: A paper currency that the bearer can have converted into an equivalent amount of gold or silver and thus has intrinsic value. Also called Commodity Money.

Fiat Currency: A paper currency that's value is assigned to it by the government or central bank and is thus entirely artificial.

Inflation: A sustained rise in prices caused by the amount of cash in circulation being greater than the intrinsic value of goods and services available for purchase.

Marginal Productivity of Capital: The increase in the value of the firm's output when one more unit of capital services is employed.

Monetary Stock: Coins, paper currency, traveler's checks and checking account deposits.

Precautionary Demand for Money: A Keynesian term used to describe income cash held in reserve to meet sudden, unexpected expenditures.

Quantity Theory: In its most basic formulation, the theory asserts that prices will rise in direct proportion to an increase in the money stock.

Real vs. Nominal Value of Money: The real purchasing power of a currency versus its face value.

Specie: Metallic coins. For much of our recorded economic history, said coins contained a small, fixed amount of silver that had intrinsic worth.

Speculative Demand for Money: A Keynesian term used to describe income put into time-deposit accounts and other financial instruments for the express purpose of earning a profit.

Transaction Demand for Money: A Keynesian term used to describe income spent as cash on immediate purchases.

Velocity of Money: The rate at which the money stock is transacted. i.e. the number of times currency in circulation changes owners over a set period of time.

Bibliography

Arestis, P., & Mihailov, A. (2011). Classifying monetary economics: Fields and methods from past to future. Journal of Economic Surveys, 25, 769-800. Retrieved on November 16, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=62977268&site=ehost-live

Brunner, K., & Meltzer, A. (1972). Friedman's monetary theory. Journal of Political Economy, 80, 837. Retrieved September 25, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=5054529&site=ehost-live

Clever, T. (2002). Chapter 7: Money, banking and international finance. In Understanding the world economy. Oxfordshire, UK: Routledge. Retrieved October 7, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=16867388&site=ehost-live

Davidson, P. (1978). Why money matters: Lessons from a half-century of monetary theory. Journal of Post Keynesian Economics, 1, 46. Retrieved September 25, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=8626305&site=ehost-live

Glasner, D. (2000). Classical monetary theory and the quantity theory. History of Political Economy, 32, 39-59. Retrieved September 25, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=3327291&site=ehost-live

Handa, J. (2000). Chapter Two: The analysis of money and prices: The heritage. In Monetary economics. Oxfordshire, UK: Routledge. Retrieved September 25, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=17412927&site=ehost-live

Harcourt, G. C., & Kriesler, P. (2011). The enduring importance of the general theory. Review of Political Economy, 23, 503-519. Retrieved on November 16, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=66825687&site=ehost-live

Rashid, S. (2012). Importing the unusable: The Quantity theory and the LDC’s. Journal of Developing Areas, 46, 385-396. Retrieved on November 16, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=73369656&site=ehost-live

Zijlstra, J. (1979). Monetary theory and monetary policy a central banker's view. De Economist, 127, 3-20. Retrieved September 25, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=17877529&site=ehost-live

Suggested Reading

Moore, B. (1978). A post-Keynesian approach to monetary theory. Challenge, 21, 44. Retrieved September 25, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=6116680&site=ehost-live

Salerno, J. (2006). A simple model of the theory of money prices. Quarterly Journal of Austrian Economics, 9, 39-55. Retrieved September 25, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=23614590&site=ehost-live

White, L. (1999). Hayek's monetary theory and policy: A critical reconstruction. Journal of Money, Credit & Banking, 31, 109-120. Retrieved September 25, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=1540028&site=ehost-live