Value of money

Its Meaning :

The term 'value of money' has been variously used. Thus, it may mean:-

(i) its command over a definite weight and fineness of gold or silver, as is the case under gold and silver standards respectively, or

(ii) the units of foreign currency that it will purchase (e.g., £1 =.) or

(iii) its command over goods and services with a country, i.e., the internal purchasing power of money. When we use the term "the value of money" without qualification, we mean it in the third sense.

The value of money is the quantity of goods and services in general that will be exchanged for unit of money. In other words, the value of money is its purchasing power, i.e., the quantity of goods and services that a unit of money can purchase. It should be noted that the value of money, or its purchasing power, has a definite, though inverse, relation with the general level of prices in a country. When general price level rises, the value of money falls and conversely, when general price level falls, the value of money rises.

There are three principal approaches to monetary analysis:

(1) The Quantity-Velocity Approach or Cash Transaction Approach

(2) The Cash Balances Approach.

(3) The Income-Expenditure Approach.

The first two, viz., quantity-velocity approach and the cash balances approach are grouped together as the quantity theories of money. The income-expenditure theory is generally considered the modern theory.

QUANTITY THEORIES OF MONEY

Most economic historians who give some weight to monetary forces in European economic history usually employ some variant of the so-called Quantity Theory of Money. Even in the current economic history literature, the version most commonly used is the Fisher Identity, devised by the Yale economist Irving Fisher (1867-1947) in his book The Purchasing Power of Money (revised edn. 1911).

Statement of the Theory:

Basically, the quantity theory of money states that other things remaining constant, changes in general price level are to be explained with reference to changes in the quantity of money in circulation so that an increase in the quantity of money leads to a rise in the price level, while a contraction in the quantity of money will lead to a fall in general price level.

In an extreme version of the theory, it is asserted that, other things remaining the same, the value of money falls proportionately with a given increase in the quantity of money. Conversely, the value of money rises proportionately with a given decrease in the quantity of money.

In other words, the changes in the general price level, other things remaining the same, are directly proportional to changes in money supply. Double the quantity of money and the price level will be doubled.

Qualifications - there should be no change in the following factors while the quantity of money changes:—

(1) Velocity of circulation of money. Velocity or rapidity of circulation of money means the number of times a money unit changes hands. If, for instance, during a given period, a five taka note changes hands five times, then the quantity of money in this case will be Tk. 25 and not Tk. 5. If the velocity of circulation increased, the same supply of money would purchase more goods and services.

(2) The use of credit instruments as money. If there is an increase (or decrease) in the use of credit instruments, such as cheques, book credit, etc., it should be regarded as an increase (or decrease) in the quantity of money in circulation. Similar is the case as regards the velocity of circulation of credit instruments.

(3) Barter transactions. If some exchanges are done without the use of money, they should either be excluded altogether or be regarded as an increase in the quantity of money (supply) or decrease in the quantity of transactions (or demand for money).

(4) Finally, the volume of transactions must remain constant. This means that the work to be done by money, or the transactions to be performed, must remain the same. Not only the amount of goods exchanged, but also the number of times goods change hands (rapidity of circulation of goods) must remain constant. In a word, other things being equal, the value of money varies inversely with its quantity and directly with the volume of goods and services in existence.

Equation of Exchange:

Professor Irving Fisher has expressed the relationship between the quantity of money and its value in the form of a formula, which he calls the equation of exchange. This is:—

' MV+M'V

Here P = Price level, or P = the value of money;

T = Transactions to be performed by money;

M = Metallic money; M ' = credit money;

V = Velocity of metallic money; and V ' = velocity of credit money.

This formula equates the supply of money to the demand for it. Price level multiplied by the transactions gives the total value of Transactions which means demand for money (PT). This is equal to the supply of money which consists of cash and credit instruments with their velocities of circulation (MV+M'V).

Thus PT=MV+M'V'

Professor Fisher contends that, in the short period, T. V, V' remain constant. The proportion, of M' to M also remains constant. Therefore, P varies directly with M. In other words, 1/P (value of money) varies inversely with M or quantity of money in circulation.

Why do "other things (T, V, V' and proportion of M' to M) remain constant? Professor Fisher holds that: Transactions or amount of work to be done by money remains constant in the short period, because in the short period, population is fixed, production per head of population is fixed, percentage of consumption by producers does not change, percentage of exchange by barter does not change and the rapidityr of circulation of goods does not change. Methods of production and habits of the people in this connection are practically fixed. Thus, the demand for money remains constant.

As regards the supply side, rapidity of circulating of money and credit depends upon custom and business habits of the people. The proportion of M' to M depends upon the policy of the banks. These things also do not change appreciably in the short period. Hence, we can say that the value of money varies inversely with its quantity.

Critical Evaluation of the Quantity Theory:

The Quantity Theory has been widely criticised. It is a static theory, whereas the real world is dynamic where changes are constantly taking place. With the qualification "other things remaining the same" it is a useless truism. They change not only in the long period but also in a comparatively short period. Population, amount of business transacted per head of the population, velocity of circulation, policy as regards the proportion of credit to cash all are subject to change and changes in them are constantly taking place.

Thus, many factors, other than the quantity of money, may bring about a change in the price level, and hence the value of money, e.g., change in the volume of trade, improvement in transport facilities, gold movements, extension of banking and credit facilities, etc. Hence, exclusive emphasis on the quantity of money is not proper.

Process Not Spelt Out. The quantity theory is said to be only a short-hand expression and does not fully explain the whole process by which a change in the quantity of money brings about a change in the price level or the value of money.

Money Not Merely a Medium of Exchange. Fisher's theory regards money as merely a medium of exchange which must be exchanged for goods. But money may be wanted for its own sake to be held as idle cash balances. It is also a store of value and may be wanted for speculative purposes.

Not Independent Variables. These factors are not independent. For instance, a change in M in itself may cause a change in V, and thus cause a change in P more than in proportion to a change in M. After the First Great War, the German Mark was depreciating fast and no one was willing to hold it. The rapidity of circulation money (V) increased progressively and out of all proportion to the increase in the note issue (M). Similarly, a change in M may cause, and does cause, frequently a change in T, and a change in P may lead to a change in M. An increase in the supply of money may raise prices, increase profits and stimulate production beyond the profitable level again depressing prices. Moreover, higher price level may necessitate the issue of more money to carry on transactions. Thus, high P may be the cause rather than the effect of the increase in M. M and V Differ. M refers to a point of time and V to a period of time, and it is wrong to multiply two different things, e.g., MV.

Wrong Assumptions. Basically, for the quantity theory to be true, the following two assumptions must hold: —

(i) An increase in money supply leads to an increase in spending, i.e., no part of additional money created should be kept in idle hoards.

(ii) The resulting increase in spending must face a totally inelastic supply of output.

Both the assumptions lack generality and, therefore, if either of them does not hold, the quantity theory cannot be accepted as a valid explanation of the changes in price level.

Under first assumption, there is no such direct link between the increase in the quantity of money and the increase in the volume of total spending. No one is going to increase his expenditure simply because the government is printing more notes or the banks are more liberal in their lending policies. This is not to say, however, that changes in the quantity of money have no influence whatsoever on the volume of aggregate spending. Changes in the quantity of money are sometimes capable of inducing changes in the volume of aggregate spending. So there does not exist a direct, simple, and more or less a proportional relation between variation in money supply and variations in the level of total spending.

The second assumption will be valid only under conditions of full employment. A totally inelastic supply of output is assumed when all the available resources are being already fully utilised. In conditions of less than full employment, the supply of output will be elastic. Now, if we assume that aggregate spending increases with an increase in the quantity of money, it does not follow that prices must necessarily rise. If the supply curve of output is fairly elastic, it is more likely that the effect of an increase in spending will be more to raise production rather than raise prices. Of course, at full employment, every further increase in spending must lead to an increase in prices as output is inelastic in supply. Since full employment cannot be assumed to be a normal feature, we cannot accept the theory as a valid.

Not useful. It is also criticised on the score of its utility. It is not regarded as helpful either as an analytical tool or as a guide to policy. It is pointed out that neither the volume of transactions nor the velocity of money is stable.

Merits of the Theory:

Although it is widely criticised by modern economists and is rejected as an adequate explanation of the value of money, it has some merits too.

(i) It is historically true for whenever there has been over issue of currency, prices have invariably risen. The currency history of every country has demonstrated it.

(ii) The practical utility of the theory is evident from the fact that whenever the monetary authorities seek to control prices they do so by regulating and controlling the issue of currency. The manipulation of the bank rate and open market operations of the central bank are based on this assumption.

(iii) Although every change in the quantity of money may not produce a proportionate change in the price level, yet the theory seems to be broadly true.

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