Economic Analysis Essay
Money is a medium of exchange. In every economy, the circulation of the money is a paramount driver that necessitates the production and gives incentive to production of goods and services. As a result, money is an important tool in gauging the economic performance of any given economy. As a matter of fact, money is an efficient measure of wealth and therefore, the level of production. Consequently, the GDP of any country can therefore be compute in a number of approaches, among them being the income approach which implies the monetary capacity of an economy. Consequently, money is a very important tool in the computation of various economic measures and in the evaluation of the people’s standards of living. However, the standards of living are not directly proportional to the level of GDP of a country. Thus, high GDP is not necessarily an indicator of high standards of living and vice versa. Therefore, we can define the term money as the unit of measurement of economic performance of an economy. Consequently, the amount of money in circulation in a given economy is an important aspect of planning for every central bank of any economy.
There are various theories that have been put for to describe money as far as various aspects of money are concerned. This essay will however focus on the quantity theory of money. The quantity theory of matter postulates that there is a positive relationship that exists between a change in money supply and the respective long-term prices of commodities. Consequently, a rise in the money supply within a given economy results in a proportional rise in the prices of commodities. In particular, money supply is the product of prices and the volume of transactions incurred within a given economy, divided by the respective velocity of the money in the economy based on the Fisher Equation. This theory originated in the 16th century after the economic aftermath of inflation resulting from increased imports of silver and gold from the United States of America. Indeed, if the volume of transaction and the velocity of money are held constant, any increase in money supply results in a proportional rise in the prices of commodities (Snowdon & Vane 2005).
Money is demanded within the economy by an infinite number of factors. In essence, consumers need money to purchase goods and services. For instance, having many ATMs within a consumer’s reach is an incentive for low demand for money with the consumer. In this case, as the money is available at any time, they need it for transactional purposes. Indeed, the main determiner of the demand for money and so the level of money supply is the average prices in the economy. High price level of commodities produces a proportional rise in the level of money demanded by the consumers in an economy. This is due to reduced purchasing power of the currency. One of the major causes of this is economic failure, which results in price levels rise and a consequential drop in unemployment as illustrated by the Phillip’s curve. Conversely, if the price levels in an economy go down, the purchasing power of the currency goes up. Consequently, the demand for money by the consumers also declines (Snowdon & Vane 2005).
As a matter of fact, the equilibrium determinant of the value of money is the product of the intersection between the supplies of money, which is controlled by the Federal Reserve System (Fed), and the money demanded, which is created by the users. These therefore characterize the money market in an economy. Indeed, the supply curve is vertical in appearance because the availability of money is determined by the Fed without prior consideration of the actual value of money. On the other hand, the money demand curve slope downwards since a decline in money value leads to a rise in consumers’ money use, thus a higher demand for money due to low purchasing power of the currency. Likewise, high purchasing power of the currency results in a reduced demand for money by the consumers due to the high value of the money. In summation, the point of intersection between the supply and demand curves of money denotes the equilibrium levels of both value of the currency as well as the price levels (Snowdon & Vane 2005).
The money market denotes the value of money as a variable. Change in demand for money as well as the change in the money supply results in a consequential change in the value of money as well as the aggregate prices of the commodities in the economy. However, the change in price levels and the money value are of the same proportion but assume different direction. In this regard, the quantity theory is a function of increment in the money supply. This theory also depicts that, the value of money in an economy is grossly determined by the amount of money in circulation within the respective economy. Consequently, this theory assumes that an increase in money supply takes place due to the rise in the increase because of the injection from the Fed, then, the value of money declines considerably while at the same time the level of prices appreciates. As a matter of fact, this theory states that the excessive growth in the money supply is the key determiner of inflation level of a given economy (Dean 1965).
Besides a hypothetical economy, the demand for money, its value, level of prices as well as the money supply is key valuables in real economy. However, the interconnection of the valuables is not perfect as depicted in the quantity theory of money as well as the diagrammatic money market disposition. Indeed, there are other various variables that mediate between the interplaying factors. On the contrary, there exists a number of factors that dictates in one way or the other the supply and demand for money. These include the velocity of the money within an economy as well as the amount of transactions that an economy experiences within a given fiscal period (Dean 1965).
On the other hand, Keynes put forward the liquidity preference theory. This theory dictates the overwhelming facts about money supply and the contrasted money demand whose interplay brings about the equilibrium quantity of money supply and price levels in an economy. However, unlike the depiction of quantity theory of money, Keynes describes the money supply as a function of interest rates to an extent but fixed by the authorities, the central banks of a given economies. Consequently, interest rates are bound to be manipulated as the authority pleases. According to Keynes, liquidity preference is the yearning of the consumers to keep cash with a view to make purchases and for a security purpose. Indeed, the bigger the liquidity preference is, the bigger the resultant interest rates imposed on the holder in order to persuade them to offload the huge value of liquid capital (Dean 1965).
In essence, Keynes states that unlike the instance whereby the supply of money in the quantity theory is dictated by the prices and the volume of transaction within the economy, Keynes proposed that the amount when the interest rates are low, people within the economy tend to withdraw more money and therefore, retain a huge percentage of the money value in a liquid form. This therefore increases money supply within the economy. Consequently, the banks respond by raising the interest rates which gives the consumers an incentive to deposit most of their cash and therefore, reduce money in a liquid form. As a result, the amount of money held by the consumers declines. in Keynes’ view, the money value dictates the amount of money to retain with the consumers. As a matter of fact, a decline in the money value results in a low purchasing power of the currency. Consequently, people tend to withdraw more money to cater for the transactional purpose of the currency while maintaining a balance in the quantity consumed. In essence, Keynes argues that low liquidity preference results in low money supply and vice versa (Paden 1975).
On the other hand, other than the transactional motive of retaining money, Keynes argued that consumers also reduce money supply by holding certain proportion for the purpose of incurring transactions. Indeed, this demand associates the need for holding currencies for the sake of carrying out individual as well as business exchanges. However, according to Keynes, the money held for transactional motive can further be divided into earnings and trade purposes. However, Keynes is highly criticized for not imputing investment demand function, savings and the volume of money functions into his arguments, which are irrefutably core determinants of money supply. Indeed, just like the classical thesis of interests, Keynesian approach is undefined. On the contrary, Keynes concentrates most on the liquidity preference as well as the volume of money as the determiners of the rates of interest and therefore, the determinants of money supply, which in essence does not hold.
Keynes also sought to criticize the old classical theory. Indeed, the orthodox doctrine further states that consumptions, gross investments as well as the savings are all functions of rates of interests within a given economy. In addition, the rate of interest is further determined by the supply and demand for the loanable funds. According to the implication of the findings from this doctrine, further argues that given the interest rates remain adequately flexible, the proportions of savings are automatically converted into investments as in the national savings. Furthermore, Say’s law implies that the optimal supply of savings and demands for loanable funds, which is the fraction deviated to investment equilibrate at the point of full employment. This is the point at which all people who are willing and are capable of working can secure employment. However, according to the Phillips curve, at this point the rate of inflation is quite high and therefore, not conducive for the country’s economy (Mcafee & Lewis 2009).
There exists inadequate financial supply due to excess savings that the consumers within the economy are incurring or less investments which cannot stir up equilibrium in the involuntary unemployment. On this note, Keynes disputed on loanable funds theory which owes its origin from the treatise of currency. According to the models developed by Keynes in this dispute, there exist two key features, namely the consumption is taken to be a function of returns, and the fact that Keynes treats savings as a function of both incomes and the rates of interests. These models were designed to explain the dynamics in the behaviors of the general price level. However, the treatise model, which intended to express the behavior of the general prices, prevented Keynes from developing the models any more until he rose up to reexamine the implications laid out in the treatise model. From his findings, Keynes resolved that there is a great variance in the factors that determines the consumption, savings pattern, decisions within the set up of a household and the pattern in a business set up (Mcafee & Lewis 2009).
According to the old classical dichotomy of economy, Keynes rebuffs all the economic models raised prior to his. In the old classical economic model, the Cambridge cash-balance theory with respect to the quantity theory of money attached particular importance to other factors that would determine demand for money. Indeed, the Cambridge cash-balance theory emphasizes on the aspect of money as a ‘temporary abode for purchasing power’ and accorded due attention to the individual consumption capacity that needed money in order to meet. Consequently, this was a major step to singling out money value as the main determinant of money demanded. However, Keynes revived his perception towards money supply and demand. In particular, Keynes redressed the issue of the contemporary monetary flow by dropping the aspect of interest rates as the backbone determiner of money supply and in coordinator of the decision making within the economy (Friedman 1956).
In addition, Keynes put forth subjective theory of probability. This theory described a certain degree of belief concerning a prime scheme grounded on an existing reality but in relation to the prime scheme or proposition. Therefore, given the situation at stake, individuals may be reluctant in making decisions subject to consumption and savings. Availability of more information may therefore trigger the incentive of the consumers to incur the respective expenditure. Indeed, out of the relationship between the prime proposition and the additional data concerning, it serves primly in the formation of short-term expectations that further trigger decision-making of Keynes’ clients besides shaping savings preferences basing them on the individuals’ contemporary disposable incomes. Finally, other than interest rates, the central bank may also check the circulation of money through other viable mechanisms. In order to reduce money in circulation, the central bank may opt to sell bonds and securities to the public while buying may be done to mitigate the supply of money (Friedman 1956).
In conclusion, money demand and supply is a function of many factors. The central bank in an economy serves to set the interest rates under which other financial institutions below it set theirs. Interest rates dictate value of loanable funds available to the consumers and therefore, the money supply. Furthermore, low interest rates motivate or discourage consumers from storing their money with the banks. As a result, the consumers engage in recurrent withdrawals until the financial flow in circulation reaches equilibrium. At this point further de-saving results in excess money held by the consumers in cash. As a result, banks begin to raise interest rates through the central bank; thus, consumers begin to bank excess money they are holding until the interest rates begin to drop again and the cycle continues.