Nedith Rachelle L. Rocillo BS Travel Management. Explains the role of money in the economic system.

Nedith Rachelle L. RocilloBS Travel Management

MONETARY THEORY

Explains the role of money in the economic system.

Monetary Theory

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Goods and Services

Why do prices increase?

Why does production decline?

the theory of the value of money. Monetary Theory

Three theories: (changes in the value of money)

1. Transaction theory

2. Cash-balance

3. Income theory

Value of money

Flow or use of money and not its value – which causes changes in economic activities.

Finance Charge A fee charged for the use of credit or the extension of

existing credit.

interest, fees, service charges discounts, and such other charges incident to the extension of credit

Creditor Any person engaged in the business of extending credit

who requires as an incident to the extension of credit, the payment of a finance charge.

1. The cash price or delivered price of the property or service to be acquired

2. The amounts, if any, to be credited as down payment and/or trade-in

3. The difference between the amounts set forth under clauses (1) and (2)

4. The charges, individually itemized, which are paid or to be paid by such person in connection with the transaction but which are not incident to the extension of credit

Information to be furnished by Creditor

5. The total amount to be financed

6. The finance charge expressed in terms of pesos and centavos; and

7. The percentage that the finance charge bears to the total amount to be financed expressed as a simple annual rate on the outstanding unpaid balance of the obligation.

Regulatory Agency. a public authority or

government agency responsible for exercising autonomous authority over some area of human activity in a regulatory or supervisory capacity.

Regulatory authorities are commonly set up to enforce standards and safety, or to oversee use of public goods and regulate commerce.

The Monetary Board of the Central Bank of the Philippines is authorized by law to prescribe rules and regulations as may be necessary to carry out the purposes there are corresponding adjustments in salaries and pensions.

But a galloping inflation

when prices are rising at double or triple digit rates of 20, 100 or 200 per cent a year.

(about 10 percent increase) becomes disruptive in investment, production andconsumption.

The worst is astronomical inflation in which the price level increases by 100 percent, 500 percent or even higher.

The inflation rate:

Based on Ibon Data bank statistics,

OCTOBER PERCENT

1983 9.10

1984 63.82

71 out of every 100 families were below the poverty line which was P2,503 a month.

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Inflation means higher cost of production.

We have to increase the prices of our

goods.

It is a basic law in economics that when prices

increase, quantity demanded

decrease (all other things being constant).

P D

When demand for their products falls, production subsequently slows down. This

means there will be an increase in unemployment.

The income theory claims that the use of money can have great influence on economic activities even though its value does not change.

The Use of Money

Income theorists believe that their theory is better than the money-of-value theories (transactions and cash-balance theory) because it clearly shows how the flow of income or money causes economic changes.

Investment, Employment, Production, and Consumption

Less production, Less Employment, Less Income, and Less Consumption

Income theorists believe that the value-of-money theories were only suitable during the early years when the economy was highly competitive, and when prices were determined by demand and supply forces.

States that the value of money (like goods and services) is determined by demand and supply in a given market at a given time.

The Transaction Theory

The three determinants of money value are the following:

average quantity of money available Average velocity, and The volume of trade

S D = P , its value falls

D S = P , its value rises

It can be stated therefore that other things remaining equal (determinants of the value of money), the general price level varies in direct proportion to the supply of money, and in inverse proportion to the demand for money.

PT = MVP 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 the year or other period of time.

V is the velocity of money in the same period or the number of times the money 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.

Transactions equation of exchange:

Supply of moneyDemand for money

To determine the price level, transpose the equation of exchange PT = MV:

PT = MV

P = MV

T T

T

Supply of Money Demand for Money

=

Price Level

What will be the P? M = 1,000,000; V = 18; and T =

12,000,000P = MV/T

=1, 000, 000(18) 12,000,000

= 18, 000,000 12,000,000

= 1.50Thus, the equation MV = PT will be:

1,000,000(18) = 1.50 (12,000,000)

18,000,000 = 18,000,000

What will be P? If there is a change on either of the following

(other factors remaining the same or constant): M is increased by 200,000 V is increased by 6 T is decreased by 2,000,000 M is decreased by 300,000 V is decreased by 6 T is increased by 6,000,000

The answers are as follows:1. P is 1.802. P is 2.003. P is 1.804. P is 1.055. P is 1.006. P is 1.00

Prices will rise if there is a corresponding increase in M or V or decrease in T.

Prices will fall if there is a corresponding decrease in M or V or increase in T.

In a nutshell, the transactions equation explains the interdependencies existing among the quantity of transactions and the level of prices over a period of time.

Cash-Balance Theory

Cash-Balance Theory Transaction Theory

• stress the value of money as the main determinant of economic activities.

• stress the value of money as the main determinant of economic activities.

•Determine the value of money through the demand and supply relationships.

•Determine the value of money through the demand and supply relationships.

•The supply of money refers to the cash-balances or money holdings of the people.

• supply of money refers to the velocity of money.

Some reasons why people like to hold cash/retain 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.

Cash-Balance Equation of Exchange:

M = KTPM 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, number of transactions or total number of goods, services, and property rights that are bought in a given period of time.

P is the average of goods, services and property rights.

Demand for money

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.

Followers of the cash-balance theory conclude that, other things remaining equal, the general price level varies in direct proportion to the supply of money, and in inverse proportion to the demand for money.

M = KTPKT

KT

P = MKT

M

KT

P

=

V in the transactions equation and the K in the cash-balance equation, are closely related. Both are determined by exactly the same forces. The velocity of money depends on the decision of owners to spend or save it.

Velocity of money becomes greater when people decide to spend their money as fast as they can. Keeping or hoarding money for future purchases, decreases the velocity of money.

V and K are reciprocal to each other. If V is 12, then K is 1/12.

What will be P? M = 1,000,000 ; K = 1/6 ; and T =

12,000,000P = M/KT = 1,000,000

1/6 (12,000,000) = 1,000,000

2,000,000 = .50

Thus, the equation M = PKT will be:

1,000,000 = (.50)(1/6)(12,000,000)

1,000,000 = 1,000,000

If there is a change on either of the following (other factors remaining the same or constant):

K is increased from 1/6 to 1/3T is increased from 12,000,000 to 15,000,000K is decreased from 1/6 to 1/24T is decreased from 12,000,000 to 6, 000,000

What will be P?

The answers for the above problems are as follows:1. P is 252. P is 403. P is 2.004. P is 1.00

Prices will rise if there is a corresponding decrease in K or T.

Prices will fall if there is a corresponding increase in K or T.

Summing it up, the cash-balance equations relate the dependencies among the supply of money, the quantity of money, and the demand for money at a given point of time.

Quantity Theory of Money Re-emphasized

States that “other things remaining unchanged, a change in the quantity of money will result in proportional changes in the price level”.

The quantity theory of money expresses the view that changes in M cannot cause changes in V and T. However, changes in M will result in proportional changes in P.

Transaction Equation (MV = PT)

MODIFIED FORM:PT = MV + M’V’

M’ refers to the amount of money substitutes (credit instruments), and V’ refers to the velocity (rapidity) of money

substitutes.

What will be P?

P = MV + M’V’T

= 1,000,000 (18) + 1,000,000 (18) 24,000,000

= 36, 000, 000

24,000,000 = 1.50

Quantity theory is a useful tool in understanding long-run monetary and economic problems. Nevertheless, its usefulness in short-run problems of economic and monetary stability is not a remote responsibility.

INCOME THEORY

Maintains that changes in the economy are not influenced by the changes in the value of money or price levels.

The theory stresses the production of new goods, and the speed of spending factor of incomes (wages, rents, interests and profits) for products.

It explains the workings of the economic system through the interactions of the various aggregates like investments, income, consumption and savings.

The value of money according to the theory is determined by the savings-investment relationship.If S = I, there is no movement in the price level.If S > I, there is a downward pressure on prices. If I > S, there is an upward pressure on prices.

Savings – refer to the supply of money and investments to the demand for money.

However, the income theorists contend that the changes in prices do not depend only on savings-investment relationships, but also on the availability of the idle factors of production (land, labor, and capital), and the degree of control made by the enterprises in the various fields of the industry.

JOHN MAYNARD KEYNES

Developed the fundamental equation Y = C + I, where

• Y being aggregate income;• C being the amount spent for goods for consumers; • I being the amount spent for, and consequently received in the production of, investment goods (capital)

From such a basic equation, other useful equations may be clearly inferred and deduced like: Y – C = S, where

• S being the amount of savings left between aggregate income less that amount spent for consumption;

Y = C + I; Y = C + S; I = Y – C. Therefore, S = I

End.