The Quantity Theory of Money

The quantity theory of money proposes that the quantity of money and price levels increase at the same rate in the long run. This concept is demonstrated by the equation of exchange.

The Equation of Exchange

M × V= P × Q = Total Spending or GDP

Where
M – Money supply
V – average no of times per year each dollar used to buy goods & services = GDP/money
P – Price level
Q –real output

As Q and V are constant and change slowly, incease in M (money supply) lead to increase in P (price) propotionally.

Demand and supply for money

Factors that influence the demand of money
Interest rate – most critical
Higher interest rate => higher opportunity cost of cash => people less willing to hold money=> lower demand for money

Inflation
Higher inflation => increase in demand for nominal money

Real GDP growth
Higher real GDP growth => increases the demand for money (nominal and real)

Demand curve for money
Graph of money demanded versus interest rates is downward sloping and depends on interest rate, inflation, GDP

Supply curve for money
Controlled by the Fed. Graph of money supply versus interest rate is a vertical line.

Actual and Potential Deposit Expansion Multipliers

Potential deposit expansion multiplier:
Increase in money supply due to one additional dollar of deposits.

Potential multiplier = 1 / Required reserve ratio.

Actual multiplier is lower due to currency leakages {some people may hold currency and not deposit it in a bank} and excess bank reserves {some banks are not able to loan out excess funds}.

Excess reserve: actual reserve – minimum required reserve

Economics functions of depository institutions

Economics functions :

• Provide liquidity – use short term deposits to make long term loans
• Lower the cost of borrowing money
• Pool the risk associated with lending money and monitor the risk

Fractional reserve banking system:
The Fed requires all deposit-taking banks to hold a fraction of those deposits as reserves. Since these reserves do not earn interest, banks try not to hold any excess reserves.

The Required Reserve Ratio:
The percentage of a particular liability category (to the bank), such as savings accounts, that must be held as reserves.