'Quantity Theory Of Money'
The concept of the quantity theory of money (QTM) began in the 16th century. As gold and silver inflows from the Americas into Europe were being minted into coins, there was a resulting rise in inflation. This led economist Henry Thornton in 1802 to assume that more money equals more inflation and that an increase in money supply does not necessarily mean an increase in economic output. Here we look at the assumptions and calculations underlying the QTM, as well as its relationship to monetarism and ways the theory has been challenged.
QTM in a Nutshell
The quantity theory of money states that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services sold. According to QTM, if the amount of money in an economy doubles, price levels also double, causing inflation (the percentage rate at which the level of prices is rising in an economy). The consumer therefore pays twice as much for the same amount of the good or service.
Another way to understand this theory is to recognize that money is like any other commodity: increases in its supply decrease marginal value (the buying capacity of one unit of currency). So an increase in money supply causes prices to rise (inflation) as they compensate for the decrease in money's marginal value.
The Theory's Calculations
In its simplest form, the theory is expressed as:
MV = PT (the Fisher Equation)
Each variable denotes the following:
M = Money Supply
V = Velocity of Circulation (the number of times money changes hands)
P = Average Price Level
T = Volume of Transactions of Goods and Services
The original theory was considered orthodox among 17th century classical economists and was overhauled by 20th-century economists Irving Fisher, who formulated the above equation, and Milton Friedman.It is built on the principle of "equation of exchange":
Amount of Money x Velocity of Circulation = Total Spending
Thus if an economy has US$3, and those $3 were spent five times in a month, total spending for the month would be $15.
More than 50% of retirement age individuals to not have enough savings
QTM Assumptions
QTM adds assumptions to the logic of the equation of exchange. In its most basic form, the theory assumes that V (velocity of circulation) and T (volume of transactions) are constant in the short term. These assumptions, however, have been criticized, particularly the assumption that V is constant. The arguments point out that the velocity of circulation depends on consumer and business spending impulses, which cannot be constant.
The theory also assumes that the quantity of money, which is determined by outside forces, is the main influence of economic activity in a society. A change in money supply results in changes in price levels and/or a change in supply of goods and services. It is primarily these changes in money stock that cause a change in spending. And the velocity of circulation depends not on the amount of money available or on the current price level but on changes in price levels.
Finally, the number of transactions (T) is determined by labor, capital, natural resources (i.e. the factors of production), knowledge and organization. The theory assumes an economy in equilibrium and at full employment.
Essentially, the theory's assumptions imply that the value of money is determined by the amount of money available in an economy. An increase in money supply results in a decrease in the value of money because an increase in money supply causes a rise in inflation. As inflation rises, the purchasing power, or the value of money, decreases. It therefore will cost more to buy the same quantity of goods or services.
Money Supply, Inflation and Monetarism
As QTM says that quantity of money determines the value of money, it forms the cornerstone of monetarism. (For more insight, see Monetarism: Printing Mone To Control Inflation.)
Monetarists say that a rapid increase in money supply leads to a rapid increase in inflation. Money growth that surpasses the growth of economic output results in inflation as there is too much money behind too little production of goods and services. In order to curb inflation, money growth must fall below growth in economic output.
This premise leads to how monetary policy is administered. Monetarists believe that money supply should be kept within an acceptable bandwidth so that levels of inflation can be controlled. Thus, for the near term, most monetarists agree that an increase in money supply can offer a quick-fix boost to a staggering economy in need of increased production. In the long term, however, the effects of monetary policy are still blurry.
Less orthodox monetarists, on the other hand, hold that an expanded money supply will not have any effect on real economic activity (production, employment levels, spending and so forth). But for most monetarists any anti-inflationary policy will stem from the basic concept that there should be a gradual reduction in the money supply. Monetarists believe that instead of governments continually adjusting economic policies (i.e. government spending and taxes), it is better to let non-inflationary policies (i.e. gradual reduction of money supply) lead an economy to full employment.
QTM Re-Experienced
John Maynard Keynes challenged the theory in the 1930s, saying that increases in money supply lead to a decrease in the velocity of circulation and that real income, the flow of money to the factors of production, increased. Therefore, velocity could change in response to changes in money supply. It was conceded by many economists after him that Keynes' idea was accurate.
QTM, as it is rooted in monetarism, was very popular in the 1980s among some major economies such as the United States and Great Britain under Ronald Reagan and Margaret Thatcher respectively. At the time, leaders tried to apply the principles of the theory to economies where money growth targets were set. However, as time went on, many accepted that strict adherence to a controlled money supply was not necessarily the cure-all for economic malaise.
Liquidity preference theory
Economist John Maynard Keynes describes liquidity preference theory in Chapter 13, "The General Theory of the Rate of Interest," of his famous book, "The General Theory of Employment, Interest and Money." Keynes said that people value money for both "the transaction of current business and its use as a store of wealth." Thus, they will sacrifice the ability to earn interest on money that they want to spend in the present, and that they want to have it on hand as a precaution. On the other hand, when interest rates increase, they become willing to hold less money for these purposes in order to secure a profit.
The idea that investors demand a premium for securities with longer maturities, which entail greater risk, because they would prefer to hold cash, which entails less risk. The more liquid an investment, the easier it is to sell quickly for its full value. Because interest rates are more volatile in the short term, the premium on short- versus medium-term securities will be greater than the premium on medium- versus long-term securities. For example, a three-year Treasury note might pay 1% interest, a 10-year treasury note might pay 3% interest and a 30-year treasury bond might pay 4% interest.
OR
In macroeconomic theory liquidity preference refers to the demand for money considered as liquidity. The concept was first developed by John Maynard Keynes in his book the general theory of employment, interest and money to explain determination of the interest rate by the supply and demand for money.
The demand for money as an asset was theorized to depend on the interest foregone by not holding bonds. He argues that interest rate cannot be a reward for saving as such because, if a person holds his saving in cash, keeping it under his mattress he will receive no interest. Keynes defines the rate of interest as the reward for parting with liquidity for a specified period of time. According to him, the rate of interest is determined by the demand for and supply of money.
Liquidity preference means the desire of the public to hold cash. According to Keynes, there are three motives behind the desire of the public to hold liquid cash: (1) the transaction motive, (2) the precautionary motive, and (3) the speculative motive.
1: Transaction motive: people prefer to liquidity to assure basic transactions, for their income is not constantly available. The amount of liquidity demanded is determined by the level of income. The higher the income the more money demanded for carrying out increased spending.
2: The precautionary motive: people prefer to have liquidity in the case of social unexpected problems that need unusual costs. The amount of money demanded for this purpose increases as income increases.
3: speculative motive: people retain liquidity to speculate that bond price will fall. When the interest rate decreases people demand more money to hold until the interest rate decreases, which would drive down the price of as existing bond to keep its yield in line with the interest rate. Thus the lower the interest rate, the more money demanded and vice versa.
According to Keynes, the higher the rate of interest, the lower the speculative demand for money, and lower the rate of interest, the higher the speculative demand for money. Algebraically, Keynes expressed the speculative demand for money as
M2 = L2 (r)
Where, L2 is the speculative demand for money, and
r is the rate of interest.
Geometrically, it is a smooth curve which slopes downward from left to right.
Now, if the total liquid money is denoted by M, the transactions plus precautionary motives by M1 and the speculative motive by M2, then
M = M1 + M2. Since M1 = L1 (Y) and M2 = L2 (r), the total liquidity preference function is expressed as M = L (Y, r).
Supply of Money: The supply of money refers to the total quantity of money in the country. Though the supply of money is a function of the rate of interest to a certain degree, yet it is considered to be fixed by the monetary authorities. Hence the supply curve of money is taken as perfectly inelastic represented by a vertical straight line.
Determination of the Rate of Interest: Like the price of any product, the rate of interest is determined at the level where the demand for money equals the supply of money. In the following figure, the vertical line QM represents the supply of money and L the total demand for money curve. Both the curve intersects at E2 where the equilibrium rate of interest OR is established.
If there is any deviation from this equilibrium position an adjustment will take place through the rate of interest, and equilibrium E2 will be re-established.
At the point E1 the supply of money OM is greater than the demand for money OM1. Consequently, the rate of interest will start declining from OR1 till the equilibrium rate of interest OR is reached. Similarly at OR2 level of interest rate, the demand for money OM2 is greater than the supply of money OM. As a result, the rate of interest OR2 will start rising till it reaches the equilibrium rate OR.
It may be noted that, if the supply of money is increased by the monetary authorities, but the liquidity preference curve L remains the same, the rate of interest will fall. If the demand for money increases and the liquidity preference curve sifts upward, given the supply of money, the rate of interest will rise.
Criticisms: Keynes theory of interest has been criticized on the following grounds:
1. It has been pointed out that the rate of interest is not purely a monetary phenomenon. Real forces like productivity of capital and thriftiness or saving by the people also play an important role in the determination of the rate of interest.
2. Liquidity preference is not the only factor governing the rate of interest. There are several other factors which influence the rate of interest by affecting the demand for and supply of investible funds.
3. The liquidity preference theory does not explain the existence of different rates of interest prevailing in the market at the same time.
4. Keynes ignores saving or waiting as a means or source of investible fund. To part with liquidity without there being any saving is meaningless.
5. The Keynesian theory only explains interest in the short-run. It gives no clue to the rates of interest in the long run.
6. Keynes theory of interest, like the classical and loanable funds theories, is indeterminate. We cannot know how much money will be available for the speculative demand for money unless we know how much the transaction demand for money is.
Portfolio management theory
A theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward.
Also called "portfolio theory" or "portfolio management theory."
According to the theory, it's possible to construct an "efficient frontier" of optimal portfolios offering the maximum possible expected return for a given level of risk. This theory was pioneered by Harry Markowitz in his paper "Portfolio Selection," published in 1952 by the Journal of Finance.
There are four basic steps involved in portfolio construction:
-Security valuation
-Asset allocation
-Portfolio optimization
-Performance measurement
Concept
The fundamental concept behind MPT is that the assets in an investment portfolio should not be selected individually, each on their own merits. Rather, it is important to consider how each asset changes in price relative to how every other asset in the portfolio changes in price.
Investing is a tradeoff between risk and expected return. In general, assets with higher expected returns are riskier. For a given amount of risk, MPT describes how to select a portfolio with the highest possible expected return. Or, for a given expected return, MPT explains how to select a portfolio with the lowest possible risk (the targeted expected return cannot be more than the highest-returning available security, of course, unless negative holdings of assets are possible.)
Therefore, MPT is a form of diversification. Under certain assumptions and for specific quantitative definitions of risk and return, MPT explains how to find the best possible diversification strategy.
