Why we give money to its value? Money has value because of its general acceptability. We accept paper dollars because we know that other people will accept dollars later when we try to spend them. Money has value to people because it is widely accepted in exchange for other goods that are valuable.
Money and the price level
Question: Do changes in the money supply affects the price level in the economy?
Answer: classical economists beloved so their position was based on the equation of exchange and the simple quantity theory of money.
Equation of exchange:
Velocity of money formula is
MV = PQ
Where, M = money supply
V = velocity
P = price level
Q = Real GDP
We can also write,
Velocity of money = Nominal GDP/Money supply
Velocity of money (V):
Velocity is the number of times that money must change hands in economic transactions during a given year forms an economy to reach its GDP level.
Velocity of money = $5 trillion per year/$1 trillion
= 5 times per year.
We have equation of exchange,
MV = PQ
Or, P = M.V/Q
Therefore money supply (M), velocity (V) and real GDP (Q) determine the price level (P).
- An increase in M or V or a decrease in Q will cause prices to rise which we called inflation.
- A decrease in M or V or an increase in Q will cause prices to fall which we called deflation.
Money and interest rates:
The economic variables which are affected by a change in the money supply
- Liquidity effect: The supply of loan able funds.
- Income effect: Real GDP.
- Price level effect: The price level.
- Expectations effect: The expected inflation rate.
What is hyperinflation? Economist call the inflation rate which is very high over 50% per month which is approximately 13000% per year is hyperinflation.
Hyperinflation occur when government con not borrow from the public and is forced to print new money. To stop hyperinflation, it is necessary to eliminate the government deficit. Once the government stops printing money the hyperinflation will end.
What are the functions of money?
Definition of Money
Money is anything that serves as a commonly accepted medium of exchange or economic transactions.
Description of money’s evolution:
Some years since, Zelie a singer of the theatre Lyrique at Paris, took part in the Society Islands. She got three pigs, twenty-three turkeys (large bird), forty-four chickens, five thousand cocoanuts, besides considerable quantities of bananas, lemons and oranges. That time it became necessary to feed the pigs and poultry with the fruits.
This example describes barter (exchange goods for other goods without using money). Exchange through barter contrasts with exchange through money. Although barter is better than no trade at all.
As economics develop people no longer barter one good for another instead they sell goods for money and then use money to buy other goods they wish to have.
Function of money:
What are the functions of money? The functions of money are very important. 3 functions of money are below
- Money serves as a medium of exchange.
(i) A medium of exchange is the property of money that exchange is made through the use of money.
(ii) Barter requires a double coincidence of wants. The probability that one person has what the other desires is very small. Money solves that problem.
2. Money serves as a unit of account.
(i) Unit of account is the property of money that prices are quoted in terms of money.
(ii) Money can be used to compare the relative value of goods making it easier to carry out economic transactions.
3. Money serves as a store of value.
(i) Store of value is the property of money that it preserves value until it is used in an exchange.
(ii) From the time you receive a payment until the time you make a payment you can use money to store value.
(iii)However, money is an imperfect store of value, particularly in an inflationary economy, when the real value of a nominal amount of money decreased.
Fiscal policy and monetary policy
A nation has two major kinds of policies fiscal policy monetary policy that can be used to pursue its macroeconomic goals
1. Fiscal policy: Fiscal policy consists of government expenditure and taxation. we know it from the definition of fiscal policy. Government expenditures come into two distinct forms – government purchases which comprise spending on goods and services such as purchases of tanks, construction of roads, salaries for judges etc. and government transfer payments which increases the incomes of targeted groups such as the elderly or the unemployed. Government expenditure influences the relative size of collective spending and private consumption.
The other part of fiscal policy refers to the taxation. Taxation affect people’s income, subtracts from incomes, reduces private spending and affects private saving. In addition it affects investment and potential output. It affects the prices of goods and factors of production and thereby affects incentives and behavior.
Fiscal policy is primarily used to affect long-term economic growth through it impact on national saving and investment, it is also used to stimulate in deep or sharp recessions.
2.Monetary policy: The monetary policy which the government conducts through managing the nation’s money, credit and banking system. Monetary policy conducted by the central bank, determines short-run interest rates. It is the monetary policy definition.
The central bank is a key macroeconomic institution for every country. Japan, Britain, Russia and the countries of European Union all have powerful central banks. In an “open economy” that is one whose borers are open to goods, services and financial flow the exchange rate system is also a central part of monetary policy.
Short-term interest rates affects credit conditions including asset prices such as stock and rates along with other financial conditions, affect spending in sectors such as business investment, housing and foreign trade. Monetary policy has an important effect on both actual GDP and potential GDP.