5. (a) Explain the significance of money. What are the purposes for demand for money?
(b) Critically cxamine quantity theory of money! What relationship does the theory
establish between price level and money supply?
Answers
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. According to the quantity theory of money, the general price level of goods and services is proportional to the money supply in an economy. While this theory was originally formulated by Polish mathematician Nicolaus Copernicus in 1517, it was popularized later by economists Milton Friedman and Anna Schwartz after the publication of their book, "A Monetary History of the United States, 1867-1960," in 1963.1
It is supported and calculated by using the Fisher Equation on Quantity Theory of Money.
M*V= P*T
where,
M = Money supply
V = Velocity of money
P = Price level
T = volume of the transactions
Description: The theory is accepted by most economists per se. However, Keynesian economists and economists from the Monetarist School of Economics have criticized the theory.
According to them, the theory fails in the short run when the prices are sticky. Moreover, it has been proved that velocity of money doesn't remain constant over time. Despite all this, the theory is very well respected and is heavily used to control inflation in the market.
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Money has various purposes for demand which also explains its significance.
a. These include -
- It serves as a medium of exchange
- It stores value and acts as an account unit.
- It facilitates division of labour and also the productivity.
- It promotes the savings of people.
- It helps in the satisfaction of customers and producers by selling and purchasing of goods.
- Money demand represents the rates and revenues. If income rises, then there will be more demand for money, thus enabling consumers to purchase more goods.
- The demand for holding money depends on the frequency of getting paid, and the cost of bank deposits.
b. Money theory of quantities states that money supply and price level are directly proportional to each other in an economy. When there is a change in the money supply, the price level will change proportionally and vice versa.
- Therefore, according to the economic theory, when there is an economic rise in the money supply, then the money value falls and the price level rises.