SOUTH EASTERN KENYA UNIVERSITY

DEPARTMENT OF BUSINESS AND ENTREPRENEURSHIP

BACHELOR OF COMMERCE

COURSE OUTLINE AND DE LIVERY FRAMEWORK FOR DFI301

Semester/Year
Lecturer/email/Address/Telephone
Time and Day
Prerequisite Introduction to Finance

MONETARY THEORY AND PRACTICE

COURSE OBJECTIVES

By the end of the course unit the learners should be able to:

-Explain the role of money in the economy

- Explain the various theories that explain how money works in the economy

Course content

TOPIC SUB-TOPIC
1.Introduction .Meaning of Money
.From a barter economy to a monetary economy
.Historical development of money –from
commodity money to e-money
.Qualities of good money material
2.The quantity theory of money and related . The classical quantity of money
controversies .The Keynesians theory
.The Monetarist theory
.Implications of the quantity theories of money
.The supply side economic policies
3.The theoretical and empirical definition of .The M1 Money
money .The M2 Money
.The M3 Money
.The M4 Money
4.The determination of money supply .Definition of money supply
.Factors affecting money supply
.Impact of supply of money in the economy
5.The role of Central authority in controlling the .The history of Central banking
money stock .Traditional roles of the central authority
.Modern role of the central authority
 .Monetary policy
.Objective of the Monetary policy
.Instruments of Monetary policy
.Limitations of monetary policies in the developing
countries
6.The interest rate structures .Factors affecting interest rates
.The role of interest rates
.Nominal and Real interest rates
.Traditional theories of the term structure:
-Expectation theory
-Maturity Preference theory
-Market Segmentation theory
-Preferred habitat theory
.The modern term structure theory
Teaching methodology

The course shall be delivered through lectures, class discussions, group discussions and presentations

Core Text

Mishkin F.S (1995). The Economics of Money, Banking and Financial Markets, Harper-New York

Other recommended reading

Jingan M.L.,(1993) ,Money ,Banking,International Trade and Public Finance,London Prentice Hall.

Course Evaluation

Continuous Assessment Tests -30%

Assignments -30%

Average for CATS and Assignment - 30%

Final Examinations - 70%

 LESSON TWO: THE QUANTITY THEORY AND RELATED CONTROVERSIES

1. CLASSICAL QUANTITY THEORY OF MONEY

According to classical Quantity theory of money, value of money depends upon Quantity of
money in circulation. Taussing defines this theory in the words “others things remaining
constant, double the Quantity of money, Price level will be twice as was before but value of
money will remain one half. Halve the Quantity of money, price level will become half as
was before, but value of money will be double”.

Irving Fisher’s version of Quantity theory can be explained in terms of ‘equation of

exchange’
MV
P = where M = Quantity of money
T
V = Velocity of money. i.e. number of times one unit of
money is used to make transactions.
T = Number of Transactions.
P = Average price of all transactions.
e.g. Given that T= 50, M = 100, V = 10
100 X 10
⇒P= = 20
50
200 X 10
But if M = 200 ⇒ P = = 40
50
Assumptions of Quantity Theory of Money
(i) Velocity of Money
If velocity of money decreases proportionate to increase in supply of money, then the
price level will remain the same and vice-versa, so it should remain constant
100 X 10
e.g = 20 if M=20, V = 5, T = 50
50
(ii) Number of Transactions
If the number of transactions increase with the increase in Quantity of money, then price
level will remain unaffected and the vice-versa. There must be no change in the number of
transactions with the change in Quantity of money,
iii) Barter Transactions.
Barter transactions must also not change with the change in Quantity of money because if goods
which were previously exchange for goods are now exchanged for money, then Quantity theory
of money will not apply.
(iv) Hoardings.
If the increased Quantity of money is hoarded, then price levels will not rise and vice-
versa.
(v) Quantity and velocity of Credit Money.
Credit money and Bank money and its velocity should remain constant.
NB.
With government intervention, with changes in M, there follows a proportionate change in
P, Hence, it is the monetary authority that changes the price levels.
The theory therefore states that the average price of transaction in an economy is
proportional to the nominal quantity of money in circulation.
e.g. Suppose M = 500, V = 50 and P = 25.
Then = MV = PT
500 X 50
⇒P= = 1000
25
Increasing M by 20% ⇒ P = M = 1.2 x 500 = 600.
∴ 600 x 50 = P x 1000
600 X 50
=P
1000
30 = P
Change in P = 30-25 = 5
5
% change in P = x 100
25
= 20%
 Thus the theory is based on the premise that demand for money is transactional. People
always spend the excess money giving rise to full employment and consequently the
number of transaction pushes up price levels.

Criticism on Quantity Theory of Money.

(i) It is based on weak assumptions. The factors which are assured to remain constant do not
remain the same over a period of time. When M changes, V and T may also change.
(ii) In this theory, it has been stated that changes in price levels are proportionate to changes in
Quantity of money but it is not essential. The prices of different commodities also do not
change at the same proportion.
(iii) Another objection is that it explains only how changes in value of money are brought
about and gives no explanation of how the value of money is determined.
(iv)This theory cannot be regarded as an adequate theory of money because it takes no account
of the rate of interest. The theory of money cannot be complete without a reference of rate of
interest.
(v) The main objection against this theory is that it is one-sided theory because it keeps in view
supply of money but ignores demand for money.

(2) CASH BALANCE EQUATION OR CAMBRIDGE EQUATION

This equation is also called the demand and supply theory of money; it was presented by the
economists of Cambridge School of thought. According to that theory, value of money is
determined at that level where demand for money and supply of money are equal to each
other i.e. an individual demand (dd) for cash balances (or nominal money) is proportional to
the individual’s money income.
If this is true, aggregate demand for money
MD = KY
Where Y is money spending on all final goods and services produced during the time
period.
K is the income velocity of circulation i.e proportion of National Income that people
prefer to hold in form of money. It represents demand for money.
Contrast this to PT = value of all transactions which include spending on intermediate
goods and financial assets as well as final goods and services.
Since Y is money National Income then it can be divided into prices and Quantity
components ⇒ Y = P x Q where P = general price level
Q = Output
⇒ MD = KPQ
Assuming further that money supply (M) is under the control of monetary authority then
M = MD
Substituting
M = KPQ
With K constant and Q fixed (full employment) then an increase in M will create excess
supply of money leading people to increase their spending directly on goods and services
so that the general price level is pulled upwards.
Liquidity trap:
M M
Interest
1 2
rate
L = f (Y,i)

i1

i2 L

Money
Supply

At this trap any attempt to increase money supply (from M1, to M2), the whole of the
increase would be added to speculative balances and interest rates will remain unchanged.
In this case the velocity of circulation falls as all increases is added to “idle” balances and
monetary policy is powerless to bring down interest rates and therefore is unable to give
any stimulus to investment and consumption.
NB:
 The major effect of the increase in Money supply is on the rate of interest. National
Income and employment will only be affected if the fall in the Interest rate causes a rise in
investment and consumption. In Keynesian model, Consumption and Investment only
respond weakly to changes in the rate of interest i.e they are Interest inelastic.
Therefore, monetary policy is not very powerful as a means of influencing output and
employment.

(3) MONETARIST VERSION OF QUANTITY THEORY

This version was presented by Milton Friedman in 1956. According to Friedman, money
has a convenience yield in the sense that holding money saves time and effort in carrying
MD
out transactions. He argued that real demand for money ( ) is a function of wealth
P
(W), the expected rates of return on various forms of wealth (r), the ratio of human wealth
to non-human wealth (w) and society’s tastes and preferences (T)
MD
∴ Real Demand for money = = f (W, r, w, T)
P
(i) Total wealth (W)
As total wealth (total of human and non-human wealth) increases, the desire to hold money
will also increase.
(ii) Expected rates of return on wealth (r)
Since the rates of return on bonds and equities represent opportunity cost of holding money,
we can expect an inverse relationship between these expected rates of return and the demand
for money. In addition to the various market rates of interests, the expected rate of inflation
should be taken into account. The higher the rate of inflation, the greater is the negative
return from holding money and the more attractive are the alternative interest bearing assets
eg bonds.
(iii) The ratio of human wealth to Non-human wealth.
The higher the w ratio, the greater will be the demand for money in order to compensate for
limited marketability of human wealth.eg let X be human wealth and Y non-human wealth.
x
∴Ratio (w) =
y
  Non-human wealth includes education and training. Human wealth is so illiquid and
cannot be sold (unless slavery).
iv) Tastes and Preference
Friedman argues that the dd for money also depends on a number of factors which are likely
to influence wealth-holders tastes and preference for money.

4) KEYNESIAN QUANTITY THEORY OF MONEY.

The Keynes theory of money was an alternative explanation of interest rate determination,
which linked the real and monetary sectors of the economy.
Keynes rejected the classical quantity theory of money for three reasons.
i) Assumptions on which the classical quantity of money were based could not hold
ii) People do hold money for more reasons than just transaction purposes.
Keynes argued that demand for money may be divided into:
- Income deposits i.e. money used to meet personal expenditures.
- Business deposits i.e. money used to meet business obligations.
- Savings deposits i.e. money used to meet personal (financial) investment needs.
The other two classifications for need for money cut across the first three above. The two
categories are:-
- Industrial circulation i.e. money used to undertake normal business operations (gathering
the factors of production, making the products and delivering it to the consumers)
- Financial circulation – money used to buy and sell titles to wealth; stocks and bonds.
Keynes argued that if the quantity of money changes, the equal proportional changes in
the general price level will be constant. However, if the quantity of money remains
constant and if the principal factors that affect financial circulation change, then the ratio
of industrial circulation and financial circulation will change resulting in a change in the
general price level.
ii) It was unreasonable to assume that output could be treated as a constant. Keynes argued that
it was equilibrium level of output that determined the equilibrium level of employment. Once
it is established that a less than full employment equilibrium is possible, then it is
unacceptable to assume that output can be taken as constant as required by the classical
quantity theory of money.
 According to the Keynesian theory, equilibrium level of income is that level where aggregate
demand is equal to aggregate supply. Aggregate demand represents total demand for
consumer goods and producer goods. Aggregate supply represents the total production of one
year in any country.
Aggregate demand may be indicate by C+1 because C represents total expenditure of one
year which is incurred on the purchase of consumer goods and 1 represents total investment
in the particular year. Similarly, aggregate supply can indicated by Y= C+S because the
market value of the total production of the year is called National Income and National
Income may be divided into consumption and saving.
Thus national income will be determined at that point where
i) Aggregate demand = Aggregate supply
ii) Total Expenditure = Total Income
iii) C + I = C+S
iv) I =S

Diagrammatically, this will be shown as below:-

Y-axis Y = C+S

Consumption and Investment Aggregate Supply Curve

C+1

E C

C+1

C M2 M M1
In the diagram, the CC curve is consumption curve which moves from left to right
upwards. Since investment remains constant or the same at levels of income, then C+1 curve
will remain parallel to CC curve. C+1 curve indicates aggregate demand or the total
X-axis
expenditure at0 different levels of income. The income will be on equilibrium at OM because
National Income and Employment Level
at this point C+1 curve and C+S curve intersect at each other. ie aggregate demand is equal
to aggregate supply or total expenditure is equal to total income when income is OM.
So EM may be called the effective demand because at this point, aggregate supply is equal to
aggregate demand. If income is higher than OM, aggregate supply will be greater than
 demand and there will be overproduction. The profits of the producers will fall and they will
produce less in the next year; so income will decrease. Similarly, if income is lower than
OM, aggregate demand will be greater than supply and it will be profitable to produce more
and more and as a result of this, income will increase. In this way, income will be determined
at OM and this is the equilibrium level of income.

IMPLICATIONS OF QUANTITY THEORIES OF MONEY.

a) Cashless Society
In today’s society we have more sophisticated ways in which paying for goods and services
is done. eg Electronic money transfer.
Cash transactions today account for only a small percentage of the total value of sales but
cash is still used for a large number of small transactions. It is unlikely that cash will be
replaced for minor day to day transactions such as for bus- fares and small purchases.

b) Globalization
It is a wide term used to describe economic, social, technological, cultural and political
changes that are increasing independence and interaction between people, firms and the
entire economies all across the globe.
An economist will be interested mostly in the following aspects of globalization.
- The increasing reliance of economies on each other through international trade for an
increasing variety of goods and services.
- Opportunities to be able to buy and sell in any country in the world.
- Increasing opportunities for labour and capital to move anywhere in the world.
- The growth of global financial markets through banks and stock exchanges.
- The impact all these changes are having on the amount and allocation of scarce resources,
economic growth, living standards and wealth.
Increasing rapid globalization has been the result of increasing wealth and the development
of new technologies and faster and cheaper communication, allowing people to order goods
and services and make payments via the internet or over a telephone from anywhere in the
world.
 Also the transition of many former planned economies to free market economies has reduced
barriers to international trade and allowed people and finance to move freely between
countries. As a result many of these economies are now growing rapidly.

SUPPLY SIDE ECONOMIC POLICIES

a) Interest rate variation
This has tended to dominate monetary policy. It has tended to be an important weapon even
when money supply targets were first introduced in late 1970’s.
However, there are many problems associated with operating of monetary policy. In
particular, interest rates do not appear to have a strong correlation with investment and
excess liquidity in the system may frustrate the Central Bank’s ability to influence the
monetary supply.
Most countries are granting their Central Banks operational independence in monetary
policy. This means that the Central Bank will set interest rates. The essential difficult of
monetary policy is that interest rates need to be changed many months before they have any
effect on inflation. An independent Central Bank can anticipate higher inflation by raising
interest rates promptly – than would be needed if the remedy was delayed. The result is small
swings in inflation and interest rates and a lower rate of interest over the medium term. All
these will faster investment and growth.
b) Fiscal or monetary policy adoption.
The debate between monetarist and Keynesian theories of money is often raised in times of
economic recession, when productivity declines and unemployment levels rise. Keynesian
Economists often seek to address weak economic conditions using Fiscal government
stimulus – efforts to increase Government expenditure, lower taxation and interest in long
term production output – with the expectation that these policies will increase economic
demand.
Monetarists, on the other hand, are more interested in increasing the supply of money
available to lenders and businesses, with the expectation that easier access to credit is more
effective in generating productive growth.
Government and Central Banks often enact policies to respond to recessions that are based to
some degree in both theories of money.
c) Increased Expenditure of Excess cash balances.
Milton Friedman in restatement of his 1956 “Quantity theory of money” argued that demand
for money depended on a stable and predictable manner on several major economic
variables. Thus if the money supply was expanded, people would not simply wish to hold the
extra ‘idle’ money balances. These excess money balances would therefore be spent and
hence aggregate demand would rise.
Similarly, if the money supply were reduced, people would want to replenish their holdings
of money by reducing their spending.
Thus, Friedman challenged the Keynesian ascertain that money does not matter – he argued
that money supply does affect the amount spent in the economy.
Differences between monetarism and Keynesian Theories of money.
1) Keynesians argue that the Central Bank should use discretion in conducting monetary policy,
while monetarists advocate a long-run money growth rule.
2) Keynesian’s still view Fiscal policy as potentially important. Monetarists are less convinced
of the usefulness of fiscal policy.
3) As a general rule, Keynesians believe that the aggregate supply curve is more horizontal than
vertical in the short-run so stabilization policy can have big impacts on output and
employment.
Because monetarists believe that the economy is in inherently stable, they tend to view the
aggregate supply curve as more vertical so discretionary stabilization policy is not important.

Diagrammatically, differences between monetarists and Keynesians

Monetarists Keynesians
1) Tie monetary policies to rules 1) Give policy makers discretion
2) Fiscal policy is not useful 2) Fiscal policy may be useful
3) Aggregate supply curve has a steep 3) Economy can be unstable. Aggregate
slope. Economy is inherently stable supply curve can be flat.
Velocity Velocity

12 12
9 9
6 6
3 3

Year
 Year

1970

1973

1976
 Keynes Criticism of Quantity Theory of money.
i) Useless truism.
With qualification that the velocity of money (V) and total output (T) remain the same, the
equation of exchange.
MV=PT is useless truism. Keynes asserts that MV and PT rarely remain the same. They
change not only in the long run but also in the short run period. Fishers equation of exchange
tells us that expenditure made on goods (MV) is equal to the value of goods and services sold
(PT). This does not hold according to Keynes.
ii) Velocity of money is not stable
To Keynes economists, velocity of money changes inversely with change in money supply.
They argue that increase in money supply, demand for money remaining constant, leads to
the fall in the rate of interest. At a lower rate of interest, people will be induced to hold more
money as idle cash balances (for speculation). This means velocity of circulation of money
will be reduced.
iii) Assumption of Constant Volume of Transactions or constant level of aggregate output is not
valid.
Keynes asserted that this is valid only under condition of full unemployment. At this level
there is total inelastic supply of output since all available resources are fully utilized. In
conditions of less than full employment the supply of output is elastic.
If the supply curve of output is firmly elastic, it is more likely that effect of an increase in
spending will be more to raise production rather than prices.
At full employment an increase in spending or aggregate demand must lead to the rise in
price level as output is elastic in supply at this level.
According to Keynesian economists, full employment cannot be easily achieved and hence
the quantity theory of money is not a valid explanation in the price level in the short run.
LESSON THREE: THE THEORETICAL AND EMPERICAL DEFINITION
OF MONEY (MEASURES OF MONEY SUPPLY)
The main reason why money supply is classified into various measures on the basis of its
functions is that effective predictions can be made about the likely effects on the economy of
changes in the different components of money supply.
The four concepts of measures of Ms include
i. Money supply M1 or Narrow Money
M1= C+DD+OD
Where M1= currency with the public
DD=dd deposits with the public in the commercial banks
OD=other deposits
M1 is the most liquid measure of money supply as the money included in it can be
easily used as a medium of exchange.
ii. Money supply M2
M2 is a broader concept of money supply than M1 .In addition to three items of
M1 ,the concept of money M2 includes saving deposits with post office savings banks.
Thus
M2 =M1+ Saving deposits with the post office savings banks

The reason why money supply M2 has been distinguished from M1 is that saving
deposits with post office saving banks are not as liquid as dd deposits with
commercial banks and as such they are not chequable accounts. However, saving
deposits with post offices are more liquid than time deposits with banks.
iii. Money Supply M3 or Broad Money
M3 is a broad concept of money supply .In addition to the items of Ms included in
M1 ,in money supply M3 time deposits with the banks are also included. Thus

M3= M1+ Time deposits with the banks

Time deposits cannot be withdrawn through cheques on them.
iv. Money Supply M4
The measure M4 of money supply includes not only all the items of M3 described
above but also the total deposits with post office savings organization. Thus,

M4= M3 + Total deposits with post office savings organization.

In summary,

M1
M2 M3 M4
=Currency+ =M1 + Savings deposits =M1 + Time deposits =M3 + Total deposits

Demand deposits+ with post office savings banks with the commercial banks +

Other deposits of CBK eg dd Total deposits of

deposits of foreign cash Balances post office

and foreign government---dd deposits savings organization

of IMF and World Bank