THE QUANTITY THEORY OF MONEY (QTM)

The theory was first build up by people like Copernicus and Jean Bodin in as early as 1566. This theory according to me is more like an econophysics model which received its popularity from Irving Fisher in 1911 and other economists like J.S Mill. There were a lot of argument on the reality of the existence of the QTM, and many theory related to the QTM came in. However, the basic conclusion of each theory even though they deviated and restated the original Quantity Theory of Money equation, remained unchanged, i.e. they all explained that price level is directly related to the money supply. Let's discuss everything one-by-one. Even though not everything is there to study for your exam, but you can always prefer to know and get knowledge.

1. The Quantity Theory Of Money - In accordance with Irving Fisher.

Also known as the Cash Transaction approach, In its simplest form, it states that the general price level (P) in an economy is directly dependent on the money supply (M), P = f(M)

If M doubles, P will also double. If M falls by half, then P will also decline by the same amount. This is the logic behind the quantity theory of money. In his theory of demand for money, Fisher attached emphasis on the use of money as a medium of exchange (this is important, if you remember I have taught you how Keynes was different from Classical economists, in the way that the classical economists only thought of money as a medium of exchange, from which came a vague definition as “Money is what money does”. But Keynes said that money also has a function of store of value, where you can always save money for future use). Demand for money is a function of income. The rate of interest has no effect on the demand for money. Fisher emphasized on the supply of money, assuming demand for money is constant. 

Fisher has explained his theory in terms of his equation of exchange: According to Fisher, the equation for QTM is given as follows:

P x T = M x V

Where P = price level, or 1/P = the value of money;
M = the total money supply in the economy;
V = the velocity of Money;
T = the total amount of goods and services exchanged for money or the transactions taken place.

The total volume of transactions multiplied by the price level (PT)
represents the demand for money.
This equation equates the demand for money (PT) to supply of money
(MV).

The truth of this proposition is evident from the fact that if M is doubled, while V, and T remain constant, P is also doubled.

Assumptions of the Theory:

1. V is assumed to be constant and is independent of changes in M.
2. T also remains constant and is independent of other factors such as M, and V.
3. It is assumed that the demand for money is proportional to the value of transactions.
4. The supply of money is exogenously given from outside the system and is a constant.
5. The theory is applicable in the long run.

This whole thing was argued by Prof. Karl Marx, where he explained that whatever is being determined should be in terms of labor theory of value, where it should be determined by the socially necessary labor time needed to produce the commodity and that the QTM is a function of quantity of commodities, the price of the commodities and the velocity. After all, it is labor who determines how much production will happen. He didn't reject Fisher's theory, but just changed the function and said that the volume of money depends on labor basically.

Likewise, Keynes came in and argued that the amount of money was determined by the purchasing power or aggregate demand.

2. The Cambridge Version of the QTM - given by Alfred Marshall, Pigou, Robertson and Keynes.

Also known as the Cash Balance approach. We shall only discuss the original Cambridge version of the QTM and would avoid the functions given by each economist in specific.

M x V = P x Y

The whole concept is the same. I have mentioned it previously as well. The only difference is that everyone who has argued has just taken a different route to explain the same thing which was first explained by prof. Irving Fisher: As Money supply increases, Price level also goes up, other things remaining intact.

Thus, the % change in M x % change in Velocity = % change in P x % change in Y

Assuming velocity and income constant, we see that the change in the constant doesn't matter and the value becomes zero. Therefore, implying the direct relation between change in M and change in P. Thus, as Money supply in the economy increases, the price level also increases.

Let's take an example to explain how the model looks like.

Suppose, M = 1000, V = 4, P = 2, and Y = 2000

Then, according to the formula,  M x V = P x Y

                                                 ⟹ 1000 x 4 = 2 x 2000
                                                 ⟹ 4000 = 4000
Now, if M rises by 50%, i.e. it increases by 1000 + 50% of 1000 = 1500, then P will also increase by 50%, i.e. from 2 to 3, i.e. now P = 3 and M = 1500, then again, 

       M x V = P x Y
⟹  1500 x 4 = 3 x 2000 
⟹  6000 = 6000

This is what happens in reality. If the govt. of India increases the money supply which has happened earlier as well, then prices in the economy rise up fast. 

Thus, as M ↑ , V constant, (M x V)↑ ⇒ P↑, Y remaining constant. 

MONEY SUPPLY (FOR B.COM 3rd Year, B.Sc/B.A 1st year)

Money supply

Definition of money: Money is defined as the stock of assets that can be readily used to make transactions. In other words, money is simply the total stock of currency in the hands of the public of any economy.

Functions of money:

1.       Medium of exchange: Money is used to buy goods and services (G&S) that individuals want. It can therefore, be used as a medium of all kinds of transactions in the economy. In any economy, the ease with which money can e converted to purchase other things is known as liquidity of money.

2.       Store of Value: money is also used to transfer purchasing power from present generation to the future or from present period to the future. Although, such store of value as a function of money is not perfect due to the possibility of inflation, which reduces purchasing power of money overtime. Yet, individuals can trade money by saving it now and spending it in the future.

3.       Unit of Accounts: In the credit market, all the lending and borrowing is recorded in terms of money. Also in any market in the economy, money is quoted as the price for the commodity or service and hence it acts as a yard- stick with which all, the economic transactions are measured.

Types of money

Money that has no intrinsic value of its own but is established as money by the governments’ order or decree is known as fiat money.

On the other hand, when some commodity is utilized as money because of its intrinsic value, then it is called commodity money. The most widespread example of commodity money is gold coins, where gold as a currency is used as money and those economies using such gold coins are said to be on gold standard.

Measures of economy

Mₒ - it comprises the total currency in the hands of the public in any economy. It is also known as the “Base Money.”

M₁ - it comprises currency in the hands of public, i.e., Mₒ, as well as demand deposits, travellers’ cheque and other chequeable deposits.

M₂ - it includes M₁ + Saving Deposits + Small time deposits + Money market mutual fund balances

M₃ - M₂ + long-term deposits + euro dollars + institutions – money market mutual funds only.

Central Bank

ASSETS	LIABILITIES
1.       Government borrowings (Domestic Credit/DC)	1.    Currency (C)
2.       Commercial bank borrowings (Discount Window Operation/DW)	2.    Reserves (R/SLR)
3.       OMOs (Government Bonds/B)
4.       Foreign Exchange Reserves (F)

Assets – Side explanation:

1.       The RBI (Central Bank) advances credit to the government as the financier of the government. In case of deficit financing, the additional government expenditure is financed by borrowing from the Central Bank.

2.       The Central Bank also provides credit to the commercial banks through the discount window mechanism when the commercial banks have shortage of funds.

3.       The Central Bank also controls the Capital market of the economy and it is the absorber of government bonds. When the Central Bank on behalf of the government operates through open market purchase of government bonds, the stock of government bonds with the Central bank goes up, this adds to the Asset value of the Central Bank.

4.       The Central Bank is also the custodian of foreign exchange reserves in the open economy. It is found that if the domestic currency appreciates then there is a fall in the foreign exchange value while if the domestic currency depreciates there is an increase in the foreign exchange reserve value.

Liabilities – Side explanation

1.       Currency – the Central Bank of any economy has the monopoly right over the issue of currency, which is then circulated among the citizens.

2.       Reserves – the Central Bank also keeps reserves in the form of Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR), which belongs to the Commercial Bank for emergency requirement in order to solve (mitigate) the problem of bank-run.

Now, the total value of assets and liabilities of the Central Bank comprises the base money or outside money or simply High Powered Money. Therefore, the high-powered money comprises the monetary base of the economy.

Therefore, from Assets side,

DC + DW + B + F = H (high powered money)  → Supply Side Equation

                                               

Similarly, from liability side,

C + R = H  →  Demand Side Equation

                                          

Commercial Bank

ASSETS	LIABILITIES
Loan (L)	Deposits (D)
Reserves (R)

Derivation of Money Multiplier

1.       Currency- Deposit Ratio- it is defined as the ratio of the amount of currency held as liquid cash in the hands of public to the amount of deposits that is saved in the banks. It is normally denoted by:-

                               β = C÷D

2.       Required Reserve Ratio, Excess Reserve Ratio and reserve Ratio- the reserve ratio gives the fraction of the deposits with the commercial banks that are withheld by them as reserves. It is normally denoted by:-

                               α = R÷D

Since R is a fraction of D for a proper banking system, hence α<1.

The total reserve of any commercial bank comprises of required reserves and excess reserves. The required reserve ratio (RRR) denotes the amount of deposits that has to be kept by the commercial bank as compulsory reserves with the Central bank. This reserve is pre-determined by the Central bank and imposed on all the Commercial Banks as a constant. However, such excess reserves are not compulsorily imposed by the Central Bank and hence its magnitude depends on the policies of individual commercial banks themselves.

Therefore, the fraction of the deposit with the commercial banks that are kept, as excess reserves are known as Excess Reserve Ratio (ERR).

                                      α      =   R÷D    =  (RR+ER)÷D

                                                               =          RR÷D    +      ER÷D

                                                               =           RRR      +       ERR

                                                               =               α₁       +         α₂ ;  where

_α1 =  RRR     (constant)

α_{2 =}   ERR   (variable)

RR – Required Reserve

ER – Excess Reserve

The ER of any commercial bank depends on market interest rate (r), discount window rate of the central bank (r_d) and future uncertainties (σ). Normally, as the ‘r’ goes up the commercial banks want to give out more loans in order to earn more profit and hold less excess reserve. 

Thus, Excess Reserve is inversely related to ‘r’, implying, ERR ∝ 1/r. Similarly, if the central bank charges a high interest rate to the commercial bank as the lender of the last resort, then commercial banks would not opt for the loan from the central bank in lieu to repay a higher amount as debt afterwards, hence they would keep more excess reserve so that they stay safe from such situation. Therefore, the higher is the r_d, the more the commercial banks keep money as excess reserves. This means that Excess Reserve is directly related to ‘r_d’, implying, ERR ∝ r_d.

In addition, w.r.t market uncertainties, we notice that the more are the market uncertainties, the riskier it will be for commercial banks to give out loans and therefore, it holds more ER. Hence, ER is directly related to market uncertainty. Thus, ERR ∝ σ.

Hence, overall, α₂= f(r, r_d, σ).

From the liability side, if you recall,

                         H= C+ R        →        (1)

The money supply in the economy is given by:-

                         M= C + D      →        (2)

      (2) ÷ (1), gives us,

   =>   M÷H = (C+D) / (C+R)

Let us divide R.H.S by D,

   =>  M/H   =   ( C/D + D/D ) /  ( C/D + R/D )  

                              

   =>  M/H   =   ( β + 1 ) /  ( β + RR/D + ER/D ) 

   Now, cross multiplying H, and putting the notations, we get, 

  M = H [ (β + 1) / (β + α₁ + α₂) ]   →  (3)

Now let, m =  (β + 1) / (β + α₁ + α₂)   →     money multiplier

=>  M = mH     →     money multiplier equation

Again, We know, α<1 

=> α + β  < 1 + β 

=> 1 < (1 + β) / (α + β)

=> 1 <  m

Where, α = α₁ + α₂

 ஃ  m>1

Thus, the above result implies that if ‘H’ increases by 1 unit, then the Money supply (M) increases by more than 1 unit, why? Because the money multiplier is greater than 1, so the effect will be greater.

PROBLEM SUM (EXAMPLE):

Given:

(i)  α1 (bar)= RR/D = 0.12, α2 = ER/D = 0, β = C/D = 0.3 , find the money multiplier and money supply amount, if High-powered money (H) is 40 billion.
(ii)  If α1(bar) = 0.2 , then what is the money multiplier value, and what is the change in money supply.

Ans.) (i)  α = α1 (bar) + α2 = 0.12 + 0 = 0.12

 ஃ  m ( money multiplier ) =  (1 + β) / (α + β)  =  (1 + 0.3)/ (0.12 + 0.3) = 1.3/0.42 = 3.095

ஃ  Money Supply = m H = 3.095 x 40 = Rs. 123.8 billion.

         (ii)  Now, if the value of α1 (bar) becomes 0.2, then α = 0.2 + 0 = 0.2

ஃ  m =  (1 + β) / (α + β)  =  (1 + 0.3)/ (0.2 + 0.3) = 1.3/0.5 = 2.6

ஃ  Money Supply = m H = 2.6 x 40 = Rs. 104 billion.

ஃ  The change of Money Supply = 123.8 - 104 = Rs. 19.8 billion.

Thus, the money supply in the economy goes down by 19.8 billion rupees.

HS (HIGHER SECONDARY) IMPORTANT QUESTIONS.

Long questions (5marks each)

Please read your books and get your concepts clear. Once you do that thoroughly, then solve these questions, it'll help you out brushing up before your exam.

Q1. Explain the relationship between TP, AP and MP.

Q2. In which stage will a producer operate?

Q3. Explain the concept of internal economies and external diseconomies.

Q4. Derive the firm's supply curve under perfect competition. Explain using the diagram.

Q5. Explain the AD-AS analysis using a schedule or a diagram.

Q6. Derive the LAC from SACs.

Q7. What are the assumptions of the marginal productivity theory of distribution?

Q8. How the interest rate is determined from the liquidity preference?

Q9. Determine the wage rate using the marginal productivity theorem.

Q10. How rent element can exist in the earnings of any factor of production?

Q11. Explain the criticism of the Recardian theory of Rent.

Q12. Distinguish between Ricardian theory and Modern theory.

Q13. Explain the Expenditure and Income method of measuring National Income.

Q14. Explain the problem of double counting.

Q15. Explain what are the leakages and injections in the 3-sector Circular flow model.

Q16. Explain the functions of Central bank.

Q17. Distinguish between Current account and Capital account.

Q18. Explain the concept of credit creation and credit control.

Q19. Find the S.D. from the following information:
        (a) 20,19,20,19,19,20
        (b) 10,9,10,9,9,10

Q20. Explain Lorenz Curve with the help of diagram.

Q21. How the exchange rate is determined under flexible exchange rate system?

Q22. What are the Causes of Poverty?

Q23. What are the causes of income inequality?

Q24. What are the different types of unemployment in India? Explain them.

TIME TRAVEL AND MULTIVERSE

What is time? Time is You. In economics, if a system is fixed, it is timeless. But, we often see changes everywhere, which is due to time. Multiverse is just a fancy name given to the concept of parallel universe, implying the existence or the study of multiple universe which have come into existence due to big bang.

Let’s take the help of Experimental economics and Islamic economics to solve the mystery of the existence of parallel universe. Imagine, we can travel through time, i.e., both past and future. This implies that our clock can tick counter-clockwise and clockwise both respectively.

Now, suppose, there is an advanced technology at hand which can detect whether the time is running on a clockwise or counter-clockwise direction. And also it gives a kind of signal to a ‘Gun’. If the former happens (i.e. if the clock ticks the way it naturally does), then the gun gets fired and kills a cat. On the other hand, nothing happens if the latter takes place. Let’s give all the scenarios going on some notations.

Before moving ahead, let us assume that there is a controlled setting in our experiment where the experimenter controls the technology. That is he/she has two choices: “ON” or “OFF”. Hence we have two cases if we live our natural lives. First, where the experimenter puts on the technology, and second where he puts it off.

Some general notations used:

TON – Means technology is on
TOFF – Means technology is off
GN – Gun stays still
GF – Gun gets fired
CD – Cat dies
CS – Cat survives

Case1: Technology is on.
                                 
    ↻   =>   TON   =>   GF   =>   CD

When the clock ticks at its natural phenomenon, then the technology gets on by our experimenter, hits the cat, and the cat dies.
Case1: Technology is off.
                                 
     ↺    =>   TOFF   =>   GN    =>   CS

When the clock ticks on a counter-clockwise direction, then the technology gets off by our experimenter, doesn’t hit the cat and the cat survives.

These two stories till now seems alright. But if we want to explain something beyond this, we should assume that at this very moment in time, wherever you are reading this article, there is some other world which is having its own day-to-day lives going on.

If this is true, then this brings us to the concept to believe that both past and the future can exist at the same time, which calls for a third case.

Case3: Technology is “on-off” at the same time.
                                 
[     ↻  +    ↺      ] [TON/OFF   =>   GF/N    =>   CD/S]

Now, opening up the brackets, we multiply both the scenarios and get both the previous cases coexisting at the same time. This third case brings us to the concept of time travel. Let’s get the equation going:

[      ↻    =>   TON   =>   GF    =>   CD] +
[      ↺    =>   TOFF   =>   GN    =>   CS]

Here, in this case we get an abnormality, which doesn’t seem Rational at the first look. So what is happening? Both! The cat dies + the cat survives, both at the same time. What does this mean? It means we have a cat which is a zombie! But wait, how’s that possible, no one has ever seen a zombie. This points out our economic experiment to call off. Now, in order to explain, how this dead-alive scenario may possibly exist, we take help of Islamic economics.

“You’ll only see what you are shown, and those who have got the power to see things, they see what you don’t”

Not to misinterpret the above quote, got the power from whom? From Allah (God)! Who has got the power? Any living creature, whether animals or humans or supernatural entity.

Now, let’s see what this would look like. This quote basically implies that if you get into time-travel, you experience things yourself. Remembering that we have three time frames; past, future, and the summation of the first two. Let’s time travel.


[       ↻   =>   TON   =>   GF    =>   CD] Y +
[       ↺   =>   TOFF   =>   GN    =>   CS] Y

Where Y stands for you.

Thus, again opening up the brackets would mean that you enter both the time frame, where one you experience a dying cat, while the other you experiences a happy living cat. But this still means that at one time point you cannot have an overlapping zone and see the other you. Hence, this is why we are unable to see a zombie cat. But, this doesn’t mean that a zombie exists! I’m trying to explain the concept of Multiverse which is possible. Edited and simplified version of the Erwin Schrodinger's Cat hypothesis.

Let’s understand this with an easier example. When you visited a beach as a child, you always wondered what is there on the other side of the ocean. If yes, then you were unable to find the answer to your paradoxical situation you were in. this means, you never had that amount of knowledge which would answer that on the other side of the ocean there is still a world like ours, who may be enjoying the same water of the same ocean as us. If you are getting to what I’m trying to explain then move on further.

According to the verses of the holy Qur’an, Surat al-fatihah (1:2); “Praise be to Allah, the cherisher and the sustainer of the worlds”. Notice, the plural form used by the Almighty. This means that God is the creator, sustainer and controller of all the worlds in our universe. This includes any inhabitants. I’m not saying aliens which you see in movies, and I really don’t know whether they exist or not. Because, Allah (God) hasn’t given us any clue in the Qur’an regarding that. He has just made us (humans) and the Jinns (more on this later). And here, inhabitants mean any creature which only Allah knows because he has all the knowledge and he knows best. But, what we can infer from here implies that there is just not our earth where life exists, there are innumerable possibilities about anything. This may sound abrupt for the first time, but with proofs I would explain that Qur’an has explained a majority of science 1400 years back which science proved it recently. Let’s start off with a major one.

THE BIG-BANG THEORY

In 1916, Albert Einstein formulated his General theory of Relativity that pointed on the fact that the universe must be expanding or contracting.

According to NASA, in 1927, an astronomer named Georges Lemaitre explained that the universe started as a single point and is expanding. Just two years later, in around 1929, Edwin Hubble noticed and proved that other galaxies were moving away from us and they were expanding.

It is indeed astonishing for a person to believe that what we came to know in the 1900s, was already mentioned in the holy Qur’an 1400 years back, well before Einstein’s and Edwin Hubble’s law. The proofs are as follows:

“And the heaven We created with might, and indeed We are its expander” (Qur’an 51:47)

“He is the Originator of the heavens and the earth” (Qur’an 6:101)

The big bang theory states that around 18 billion years ago the universe came into existence from one single extremely hot dense point, and that something triggered the explosion of this point that brought about the beginning of the universe.

“The heavens and the earth were joined together as one unit before We clove them asunder” (Qur’an 21:30)

“Do not the disbelievers see that the heavens and the earth were a closed-up mass, then we opened them out?” (Qur’an 21:31)

Other proof being the explanation of water cycle, the moon reflects the light of the sun, and also the reproduction in the plant kingdom, to name a few, have been mentioned in the Qur’an 1400 years back which science proved recently.

Once this is clear, we end up explaining the extra-terrestrial form which exists and is un-seen to our eyes. Initially, scientists believed that space and matter consisted of 4-dimensions, namely length, width, height, and time (L, B, H, and T). But, with the discovery of the dark matter, scientists have found that at least 13- dimensions exists which are beyond our comprehension. One example is “Jinns”. We are unable to see them because it is beyond our capability. For example, it is said that dogs bark for two reasons, one, when they see a thief or an unknown person, second, when they see ‘shaytaan (satan)’. While horses ‘neigh’ when they see angels. When this is true, it boils down to the fact that there are bodies which travel from other worlds into ours, it’s just that we are veiled from sight!

Just like you cannot see a data being transferred via Bluetooth or any application, you just know that it’s getting transferred from one phone to another; you cannot see the line via which the data is travelling. Similarly, you are unable to see things which other animals can see, but that doesn’t mean it doesn’t exist.

The Qur’an refers to the realm which is beyond the reach of human perception as ‘al-ghayb’, while God is spoken as the sustainer of the worlds (rabb al-alameen). He is the creator and owner and it is He who knows all the ‘ghayb’. And, as always, “Allah knows best”. (Qur'an 29:19).