CHAPTER 5

Relationship between Money and Prices

The relationship between money and prices helps in understanding the changes in the value of money. The value of money differs from the value of other objects in one fundamental respect. That is, the value of money represents the general purchasing power or command over “things in general.” High prices of other things are reflected in the low exchange value of money. Similarly, low prices of other things mean high exchange value of money. The value of money is, therefore, the reciprocal of the general price level (p) and can be expressed as 1/p. One of the basic problems is to identify the factors that determine the value of money or to explain the causes responsible for changes in the purchasing power of money. Regardless of the particular theoretical bent, almost all economists reason in terms of the quantity theory at times. What is the process that links the changes in the money supply to economic activity? This chapter explains the underlying process that links the monetary and real sectors of the economy.

Theoretical Approaches

The association between money and prices is expressed in the first crude version of the Quantity Theory of Money (QTM), which stated that the general price level is directly proportional to the quantity of money in existence. The QTM has a long history. The theory was rejected in the 1930s as a result of its failure of the conditions prevailing at the time. In the post-Keynesian era, it was restated by Friedman. A new quantity theory emerged in the late 1950s, and out of it developed the new economic school of thought called the “Monetarists.”

With the onset of the Great Depression in 1929, the quantity theory was discredited by many economists, who considered monetary policy ineffective. The quantity equations are in no sense the ultimate determinants of the prices level. Instead, they are themselves determined by a host of psychological, technical, institutional, and economic factors. Thus, the ultimate determinants of the value of money are to be found behind the quantity equations. It means that the quantity equations are too general and include too little. They conceal offsetting changes in particular sectors. The quantity theory is treated only as an imperfect and unreliable explanation of money value. It does not give any precise clue to the causal process by which the value of money is determined. None of the quantity equations shows how an increase or decrease in the quantity of money reacts upon the price level. The omission of the rate of interest as a link between money and prices is a grave defect of the equation of the quantity theory. Quantity equations indicate the result, but they do not indicate the process of the result. Thus, quantity equations are less analytical and, therefore, less practicable. The value of money is a consequence of income rather than the quantity of money. Hence, it has been remarked that “quantity equations remain the most illuminating summary of the forces determining the general level of prices or the value of money.” We may, however, conclude with Samuelson (2010) that “the quantity theory is over-simplified. But in times of inflation it comes into its own; and in these times it is so important that we should preach the quantity theory, in season and out of season.”

Keynes’s Theory of Money and Prices

Keynes tries to tackle the problem in his general theory by a restatement of the quantity theory. In doing so, he tries to integrate the theory of money with the theory of employment. Keynes enunciated the QTM as follows: “So long as there is unemployment, employment will change in the same proportion as the quantity of money.” According to Keynes, the primary effect of a change in the quantity of money on the quantum of effective demand is through its influence on the rate of interest. The immediate effect of an increase in the quantity of money is to lower the rate of interest by increasing the supply of money available for speculative motives (under the liquidity preference schedule of the community). A fall in the rate of interest, thus, brings about an increase in the level of investment (i.e., investment function constituting the effective demand rises because, given the marginal efficiency of capital, a reduction in the rate of interest will cause an increase in the rate of investment). An increase in investment through the multiplier effect on demand as a whole (i.e., consumption expenditures plus investment expenditures); leads to rise in employment, output, and income. In short, the general level of prices will not rise as output increases on account of increase in money supply, so long as there are efficient unemployed resources of every type available. But as output increases, a series of bottlenecks will be successively reached, where the supply of particular commodities ceases to be elastic and their prices will tend to rise sharply.

This is how Keynes maintains that changes in the quantity of money do bring about changes in the price level or the value of money not directly but indirectly, through affecting other elements, and that the theory of money is a part of the general theory of value. The key proposition of Keynes’s monetary theory is that changes in the demand or supply of money (and both can change) operate on the level of economic activity not directly (as in the QTM) but indirectly through changes in the rate of interest and thereby through changes in real investment in the economy. The main propositions are as follows:

Thus, the influences of M on P are seen to emerge at the end of a long sequence of relations and effects. According to Keynes, the relation between M and P is not as simple as the QTM makes it out to be. It is established through a long chain of causation as shown below:

Keynes’s restatement of the quantity theory marks a great improvement in the sense that he views the role of money in the causal process via consumption, investment, liquidity preference, rate of interest, etc. By reformulating the QTM, he conveys that there is the extreme complexity of the relationship between prices and the quantity of money in contrast to the simple immediate relationship exposed in the quantity equations given by Fisher and the Cambridge economists. Moreover, Keynes’s great merit lies in integrating the theory of money with the theory of value. Thus, Keynes in his restatement of the theory provided the missing link in the old QTM. Even the leading modern quantity theorist Professor Friedman has admitted that the relation between M and P is quite loose and undependable, as several things relating the two can change from time to time. Friedman reformulated the quantity theory to determine the quantity of money that people desire to hold.

Evaluation of Different Approaches

QTM refers to the proposition that changes in the quantity of money lead to, other factors remaining constant, approximately equal changes in the price level. The theory is derived from an accounting identity, according to which the total expenditures in the economy (MV) are identical to total receipts from the sale of final goods and services (PY). The advent of Keynesian economics in the 1930s rendered the QTM of minor importance, and it was used only for the determination of nominal magnitudes of real variables. According to Keynesian analysis, the quantity of money could not affect the real economy in any direct way but only indirectly through variations in the interest rate.

In contrast, Friedman claimed that money matters and is responsible for almost every economic phenomenon. Friedman views the money demand function as stable. Money, like any other goods, has attributes that make it useful. Friedman includes separate yields for bonds, equities, and durable goods. Friedman makes explicit the possibility of other substitutions and also allows for a shift from money directly into commodities (durable goods) as rates of return change. The effect of money supply on prices may work indirectly through variations in interest rates, which in turn induce effects on aggregate demand. The empirical evidence with respect to the effects of the money supply on the price level so far has been mixed and depends on the definitions of the money supply (narrow or broad) and the time period. Friedman’s analysis reveals that the relationship between the demand for money and interest rates is weak. This weak relationship results from the broad definition of money adopted by Friedman. From this, it follows that the causal relationship between money supply and price level is not settled yet and, therefore, continues to attract the attention of economists (Froyen 2009).

Demonetization and Quantity Equation

Chanda (2016) has sought to explain the standard version of quantity equation of money and its probable impact on demonetization. In the Indian context, the total value of all final transactions in the economy includes all informal market activities and also the black economy. The effects of demonetization will vary by sector. Transactions take place in the formal sector with both cash and other forms of money. In the short run, this sector might suffer the least. The formal sector transactions also include illegal payments—for example, property transactions and government services. If demonetization works, then in the longer run, the effect would be to reduce the portion of the price that is paid in black money in this sector. The informal sector of the economy which is not illegal but is not correctly recorded in national accounts either. Usually, the government relies on sample surveys to estimate the size of this sector to incorporate into GDP. Depending on the degree of the mismeasurement, this also leads to an underestimate of the true velocity of money in the Indian economy. One of the claimed benefits of demonetization is that it will also reduce the size of the informal sector (and increase the size of the formal sector). Since demonetization seeks to reduce corruption and if corruption were to actually decline, the portion of the price that is paid in black money in this sector should go down along with diminishing the possibility of the mismeasurement of the informal sector.