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The Quantity Theory of Money -Explain the concept of money, its functions and characteristics. -Explain the theoretical link between money and prices.

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Presentation on theme: "The Quantity Theory of Money -Explain the concept of money, its functions and characteristics. -Explain the theoretical link between money and prices."— Presentation transcript:

1 The Quantity Theory of Money -Explain the concept of money, its functions and characteristics. -Explain the theoretical link between money and prices. -Explain the Quantity Theory of Money.

2 Medium of exchange: replacement for barter (used to purchase item instead of exchanging for another i.e. barter) Standard of value: we use money to compare the values of commodities. Store of value: for the purpose of saving (as long as we are confident that it will keep/store its present value and therefore retain its purchasing power in the future when we come to use it) Means of deferred payment: being able to borrow money and pay it back over a relatively long period of time. Functions of Money

3 1.Portability: can be carried around easily (in wallet or pocket) 2.Durability: must be able to stand the test of time without disintegrating 3.Divisibility: be able to divide into smaller units to enable a wide range of transactions e.g. $1 = 100cents. 4.Recognisability: not easily copied (forged) Six Qualities (characteristics) of Money

4 Recongnisiblity

5 5.Acceptability: the legal status of money is given as legal tender by government 6.Relative scarcity: an increase in the money supply can lead to a fall in its value. People need to be confident that the value of their money will be maintained by for example the government (via controlling the amount of money circulating in the economy) Qualities (characteristics) of Money

6 RBNZ ( Reserve Bank of NZ) – Established in 1934 and is given the sole right to issue notes and coins. M1 = notes and coins held by public plus transaction account balances held at banks. M2= M1 + on call funds at registered banks. E.g. Savings accounts (usually have to go to the bank to acquire these funds) M3 = M2 + term deposits at banks and other financial institutions. Money Supply

7 An economic model used to show the link between the amount of money circulating in an economy and price (inflation) The quantity theory of money

8 Example Income Spending on Goods and services We are imagining that the money stock = 100 (M) So workers must have been paid $100 (Income) The goods that they bought were also worth $100 (Spending) – Four crates ($25 each) Money has circulated ONCE in the year. From firms to households then from households to firms. So Money stock = Price of each good x quantity of goods (Q) M = Q Assume the economy only has households and producers There are only four crates of goods produced in this economy

9 Example two Money will circulate more than once a year. Imagine money circulates four times in a year. Each time the firm pays the households $100 for their labour and households buy four crates from firms. (Total 16 crates) So Money stock (M) x the number of times the money circulates (v) = Price of each good (p) x the number of goods Q 100 x 4 = 25 x 16

10 MV = PQ M = the money stock V = the velocity/speed of circulation (the number of times a unit of currency e.g. $10 note is used in a given period of time to buy G&Ss) P = the general price level Q = total output (GDP) The Quantity Theory of Money

11 Suggests that both V (speed of circulation) and Q (output of goods and services) are constant. Therefore M (the money stock) is proportional to P (general price level). Which implies that the general price level will rise with an increase in the money stock, and fall with a decrease in the money stock. MV=PQ The Crude Quantity Theory of Money - most common theory

12 If the money supply is increased by 15% (remembering level of GDP assumed to be fixed), this will mean that there is MORE money in circulation chasing the same quantity of goods. This in turn bids up prices as the purchasing power of each dollar falls. The end result will be a proportional increase in the price level, i.e. 15% increase in P. Example of Crude QTOM M V = P Q Increases by 15% by 15%

13 Quantity Constant? It is clear, real output, can change over time. This means that the assumption that Q is constant is a weakness – This leads us to the Sophisticated Quantity Theory of Money.

14 Assumes only V (velocity of circulation) is constant, as the output of goods and services produced can change. Therefore if the money stock was to increase, this could lead to either a rise in the general price level (P) OR an increase in output (Q). If the economy is operating near full capacity there will be very little room for Q to increase, therefore the P (general price level) will rise. If the economy is operating under full capacity it has the potential to utilise idle resources to off-set inflation (rise in P). The Sophisticated Quantity Theory of Money

15 Work Book page 15 –

16 PEAK/ BOOM TROUGH/ Recession Economic activity % Change in RGDP Time Upturn/recovery Downturn PEAK/ BOOM TROUGH/ Recession Downturn Upturn/recovery THE BUSINESS CYCLE

17 Peak / upswing – High Economic Activity Low unemployment High Investment Consumer and business confidence is high. High Inflationary Pressure Downturn/Recession Reduced economic activity High Unemployment Reduced investment Unemployment increasing Consumer and business confidence is low Disinflation or deflation occurring The Business Cycle

18 When an economy is operating near its full capacity, all resources and technology are being fully utilised and output is unlikely to be able to increase to help offset the increase in money stock. The economy lacks spare resources required to produce the extra output. So real output cannot increase when money stock is increased. This means the price level (inflation) will increase. Economic activity Time Near full Capacity

19 If the economy is not near full utilisation, the there are resources available to be used to produce more output. If the economy is not near full capacity then there are resources ( Capital and Labour) available to be used to produce more output. It is possible for an increase in the money stock to be absorbed by increases in output, meaning inflation is less likely to occur. Economic activity Time Not near full capacity

20 Recession = When Real GDP falls for two successive quarters Depression = a very severe recession

21 Work book page 43-44

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