Monetary theories: Explained

Economic agents differ in terms of their holdings of currency. Some prefer to use it for transactions, while others aim to exploit it for profit.

There are numerous reasons why economic agents hold currency, and this diversity has sparked many confrontations and controversies, making the field more extensive and complex. This complexity arises from the multiplicity of theories that lack a common consensus.

This article aims to highlight this ambiguity by focusing on the monetary theories that have significantly shaped this framework:

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• Classical analysis
• Cambridge School
• Keynesian analysis
• Monetarist analysis
• Theory of endogenous money

Classical Analysis of Money

The classics develop three ideas related to money:

1. Money is merely a means of transaction.
2. Money does not influence the real economy.
3. Money influences prices.

Money as a Means of Transaction

Money is not demanded for its own sake but for what it can purchase. As Walras states, “the need for money is nothing but the need for goods that one will buy with that money.”

The utility of money lies in its role as an intermediary of exchange, enabling the acquisition of goods by exchanging them for money.

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Money Does Not Influence the Real Economy: Money is Neutral

In classical analysis, goods are demanded and supplied by individuals in specific markets. Market equilibrium is achieved independently of money, based on the interaction of supply and demand. This independence stems from a dichotomy that separates the real sphere from the monetary sphere.

This theory is founded on Jean-Baptiste Say’s law, known as the law of markets. This law ensures permanent equilibrium in the market by acting on prices. Its principles are as follows:

1. If supply exceeds demand, the existing price must decrease until the quantity demanded equals the quantity supplied.
2. If demand exceeds supply, the price must increase until demand equals supply.

According to this law, supply determines demand, and price flexibility ensures a permanent balance between supply and demand in all markets.

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The neutrality of money is expressed only in its instrumental role as a means of exchange. Meanwhile, its function as a “store of value” is not considered. According to J-B. Say, no one has an interest in hoarding money. People sell a product not to obtain money but to buy another product.

Money Influences Prices

Classical theory requires a separation between the real economy and the monetary economy. This raises the question: What effects do changes in the money supply have?

This is where the quantity theory of money comes into play, relating the amount of money in circulation to price levels. This relationship is expressed by I. Fisher’s famous equation:

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• M: the money supply, representing the amount of money circulating in an economy during a given period. This quantity does not depend on the economy’s needs but is influenced by factors such as inflows and outflows of foreign exchange.
• V: the velocity of money circulation.
• P: the general price level.
• T: the volume of transactions.

In an economy, the total value of goods exchanged during a given period corresponds to the global volume of transactions (T). To settle these exchanges, a quantity of money (M) is used multiple times at a velocity of circulation (V).

The value of exchanges (PT) must equal monetary expenditures (MV) in the same period, as demonstrated by I. Fisher’s equation.

This theory assumes that V and T are constant, given that variable T cannot be influenced by changes in M, and that the production level depends solely on the quantities of production factors (labor and capital). If variable M is multiplied by n, prices will also be multiplied by n, leading to inflation.

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The Cambridge School of Thought

The Cambridge School is primarily represented by A. Marshall and A.C. Pigou. With its contributions, this school introduces new trends. While I. Fisher adopts a transaction-based approach, the Cambridge School utilizes a cash-based approach. They reformulated the quantity theory of money to define a demand function for the first time:

Md = kPY

• Md: Demand for money
• k: The inverse of the velocity of money circulation (coefficient of money utilization: a psychological propensity or the desire to hold cash balances)
• P: The general price level
• Y: Real income

This approach prefers to use the variable ‘Y’ instead of ‘T’, considering the latter as vague, to express the ‘flow of goods and services’ produced during the analysis period.

The demand for money consists of the monetary cash balances that economic agents wish to hold during a given period. The resulting function is an increasing function of real income and the general price level.

While the Cambridge School presents significant interest, Pigou’s contribution is of great importance. This economist starts from the principle that “economic agents, aware of the function of money as a ‘store of value,’ are not indifferent to maintaining their cash balances to preserve their purchasing power in the market.”

According to Pigou, individuals want to hold a cash balance that is a function of their perceived income. This balance not only ensures current transactions but also addresses unexpected needs, known as a “security reserve.” This reserve reflects the existence of demand, implying that money has its own utility and is demanded for its own sake.

Pigou’s “real cash balance effect” suggests that agents (individuals) adjust their consumption to equalize the real and nominal values of their cash balances when prices change.

When prices fall, the real value of households’ monetary cash balances increases. To restore this value to its previous level, households must reduce their savings, leading to increased consumption.

Keynesian Analysis of Money

The Keynesian approach further enriches the field of studying money demand and recognizes the decisive role of this object in the economy. Unlike the classics, Keynes does not limit money to its transactional function but expands its scope, giving it more value and dynamism. Additionally, he addresses the issue of monetary neutrality, arguing that money is not neutral but active.

According to this economist, money is held for reasons beyond its role as an intermediary of exchange. These include the precautionary motive and the speculative motive. The former involves retaining cash balances to cope with sudden events and unforeseen contingencies, such as illness, price increases, or unemployment.

The latter, speculative motive, is more critical and assumes that economic agents hold monetary cash balances to purchase securities (bonds) at the right time (when their price falls) and sell them later when their price rises.

The demand for speculative money tends to increase when interest rates fall because, in this case, agents must wait for rates to rise again before using their cash balances to buy securities. Speculative cash balances reflect agents’ preference for liquidity, as they can choose between holding speculative cash balances or investing in securities (bonds).

The demand for money due to transaction and precautionary motives depends on income and increases with this variable. In contrast, the demand for speculative purposes is a function of the interest rate.

Keynes’ demand for money is represented as follows:

DM = L1(R) + L2(i)

• (L1) represents liquidity for transaction and precautionary motives.
• (L2) represents liquidity for speculative motives.

In his analysis, Keynes distinguishes two approaches: one relating money to financial assets and the other relating money to goods.

The first approach is based on the choice between holding money or holding securities. This relationship is governed by the concept of “liquidity preference.” Here, money is considered a store of value, a good with a zero return, zero risk, and no utility. This gives rise to the possibility of hoarding, and this idle money is called idle money.

The second approach relies on the choice between holding money or holding goods. In this case, liquidity is the instrument that facilitates transactions (buying or selling goods).

While Keynes defines the money function, his analysis also addresses monetary neutrality. According to him, money is not neutral but active. Activeness implies a link between the real and monetary spheres, and this link is expressed by the interest rate.

Based on the speculative motive, the Keynesian approach states that money influences the behavior of economic agents. Their choices depend on interest rates.

As a monetary variable, the interest rate can be influenced by increasing the money supply (increasing the supply of money). This change leads to a decrease in interest rates, encouraging economic agents to invest. Increased investment will stimulate economic activity, resulting in increased production and employment.

Monetarist Analysis

As a preamble, monetarists agree on a definition that considers money as an asset comparable to all other assets that make up the wealth of economic agents.

One of the founders of monetarist analysis is M. Friedman, who proposes a new theory of money demand, which he sees as a new formulation of the quantity theory of money.

Friedman’s analysis is based on the existence of money demand, its uniqueness (not distinguishing between money demand for transactions, speculation, or precaution, as in the Keynesian tradition), and its relation to general wealth-holding behavior. The wealth of economic agents constitutes their “patrimony.” According to Friedman, this patrimony consists of:

• Money: the only element within the patrimony with a fixed nominal value. That is, the prices of other goods vary, while a €100 bill is always worth €100.
• Bonds: non-monetary financial assets whose prices vary.
• Stocks: non-monetary financial assets whose prices vary.
• Physical capital: equipment and real estate.
• Human capital: the individual themselves, who can provide services for remuneration and invest in themselves to earn a higher income.

Generally, Friedman’s money demand depends on the following factors:

• Price
• Returns on different forms of wealth
• Tastes and preferences
• Total wealth

Unlike other theories, Friedman’s theory revolves around the concept of permanent income, suggesting that “economic agents adjust their cash balances not to their current income (current income) but to their permanent income by acting on their consumption level.”

Monetarists not only focus on presenting money demand but also explore its neutrality. Some consider money to be active in the short term but neutral in the long term, while others view it as neutral in both the short and long term.

In the short term, an increase in the money supply leads to higher prices (quantity theory of money), implying increased investment. In this case, inflation stimulates investment.

However, in the long term, employees become aware of inflation, prompting wage demands that result in increased production costs and, consequently, reduced investment. This decrease leads to higher unemployment. Money is neutral in the long term because the stimulating effect of prices on production is offset by the increase in production costs.

Theory of Endogenous Money

The theory of endogenous money posits that the quantity of money in an economy is determined by economic transactions themselves rather than by monetary authorities.

According to this theory, banks can create money by granting loans, thereby increasing the money supply. The amount of money available depends directly on banks’ lending decisions.

The theory of endogenous money contrasts with monetarist theory, which argues that monetary authorities primarily determine the money supply. It also differs from Keynesian monetary theory, which suggests that monetary policies can influence the money supply.

This theory is often used to explain the relationships between the banking sector and the quantity of money in the economy and to assess the potential effects of monetary policies on banks and the economy as a whole.

Conclusion

These monetary theories are frequently employed by economists and policymakers to understand the impacts of monetary policy on the economy and formulate appropriate economic policies.