Monetary Theories

World Monetary Theories

by Paul J. Dejillas

Professor of Anthropology


            It was Milton Friedman who perceives “money as a means for mediating and facilitating exchange (1962:14). But money, in his view, mainly mediates or facilitates economic exchanges by enabling the act of purchase and sale. In this context, Dr. Ramirez introduces the term "mediated economics," money being the mediator of exchange (1996:7).


Part 1. Monetary Theories Vying for World Power


            Money as a mediator and facilitator is governed by some rules of the games that are dictated by the market forces. Behind these rules are some theories, which espouse some assumptions and inherent beliefs about economic, political, social, and cultural lives.

What are today's prevailing theories on money as medium of exchange and transaction? What are their major concerns and preoccupations? What are their strengths and weaknesses? What kind of reality do we have under today's money-oriented economy? These are some of the questions I will try to address here.

            Economists, especially the monetarists, focus their study around the supply and demand for money. In the demand side, there is the demand theory of money, while in the supply side, we have the so-called quantity theory of money. 


The Demand Theory for Money

            On the demand side, we have the theory of the demand for money, which answers the following questions:

·         Why do people hold cash money?

·         What influences people's demand for money?

            The main proponent of this theory is Alfred Keynes. For Keynes, people possess three motives or reasons for holding cash money, namely: for transactions-motive, precautionary-motive (security reasons), and for speculative-motive. The theory focuses on the transaction demand for money.

            Money is needed to transact trade. For example, I hold money because I need it to buy food, pay my rent, to pay for my transportation expense, and so on. I also need money for precautionary measures, for unexpected expenses, and for emergency purposes, e.g., when a member of my family gets sick and need to be hospitalized, or when accidents do occur. Finally, I need cash money for undertaking profitable business that may arise in the future. It is speculated that the month of May triggers great demand for school supplies, school uniforms, school buses, etc. in view of the opening of classes in the month of June. I need to hold money to go into the small business of supplying the school needs of pupils and students.

            Under the demand theory for money, the more people have money, the more purchases or investments they will want to transact, and the more the economy becomes vibrant and alive. We are here introduced to the concept of "velocity of the circulation of money."

            From the economist's point of view, the cycle of money is one of acquisition, spending, consuming, saving, investing, and back to the cycle of acquisition, and so on.


The Quantity Theory of Money

            The main proponents of this theory are Irving Fisher, Alfred Marshall, Pigou, David Hume, and David Ricardo, among others. The quantity theory of money addresses such questions as:

·         What are the effects on the economy if society has too much amount of money in the market?

·         What are the effects if society has too little amount of money available in the market?

·         What are the effects if people hide their cash money at home and keep it from circulating in the economic system?

            The theory holds that the amount of money kept by the people influences the price of goods and services in the community or society. For example, if people and the economy have too much money available to them, prices will tend to go up, assuming that there is no increase in productivity. With prices going up, the effect is to decrease the real value of cash money. More amount of money is then needed to respond to the changes in the level of prices. The technical term for this is inflation. While inflation refers to increases in the level prices, on the other side it can be viewed as deterioration in the real value of money.

            The opposite is also true. When there is too little amount of money in the economy, prices tend to go down. The technical term for this is deflation. In this case, the real value of money increases. The theory suggests that we keep only so much money as not to cause significant changes in the level of prices. In economics, we call this equilibrium level or that point where the supply of money is equal to the demand for money.

            IN ALL THIS, who benefits and who suffers?

            Unexpected inflation favors the debtors at the expense of the creditors. If you have been paying P10,000.00 monthly for your three-years-to-pay car loan for the past two years already and suppose prices of the car have doubled, then, for the remaining years you will be actually paying only one-half or P5,000.00 of the P10,000.00 that you pay nominally to your creditor.

            However, if you are not a debtor but simply an ordinary consumer who want to purchase a particular good or service, then, you will need double the amount than you would have otherwise paid before the increase in prices. In this case, inflation is disadvantageous to consumers, but beneficial for the profit-seeking entrepreneur or producer.

            Thus, inflation and deflation can be advantageous or disadvantageous depending on whether you are a debtor or creditor, or whether you are a plain consumer or a profit-maximizing producer.

            Given the influence of money supply on prices, one of the major concerns of the theory is how to limit and regulate the supply of money if it is to maintain its value. Monetarists relegate the concern of regulating the supply of money to the government, in particular the Central Bank, because of money's tremendous impact on the macro level.

            The level of money supply in the market is, however, no longer the sole control of the Central Bank. Today, the volume of monetary transactions in the stock market is also becoming a major contributor to the level of money supply in the market. In the Philippines, people are talking of the "Binondo Central Bank" which are known to also influence the supply of money in the economy. These three big institutions in their own ways can cause the level of money supply in the economy to significantly go up or down, depending on their objectives and interests. This is an area where the politics of money can enter into the picture.

            HOW IS the level of money supply and demand regulated by the Central Bank monetary authorities? One mechanism by which monetary authorities regulate the demand and supply of money is through the interest rate. How is this done?

            This can be illustrated by a simple graph below.





     i1                                    A                                                        B                      supply












                             q1              qo                q3



            When the interest rate is at io, the money market is said to be in equilibrium, i.e., the demand for money is equal to the supply of money. When the interest rate, however, is increased from io to i1, the demand for money decreases from qo to q1, demonstrating our discussion earlier that when there is too much supply or surplus of money in the market, prices tend to go up. The amount of surplus money is measured by the line A-B or q1-q3. Our discussion here assumes that there is no change in the demand curve for money in the market.

            The utility of the above graph as a tool for economic analysis is its ability to measure visually and quantitatively any changes that occur in the market.

            At the new interest level, the market is not in equilibrium. There will eventually follow continuing adjustments in the level of supply, demand, and prices until all these market forces settle down or stabilize. Until this is achieved, instability and even social disorder or unrest can occur. But the market possesses some inherent equilibrating mechanisms to restore order and stability of the various market forces. Economists refer to this as the "invisible hands" in the market. In reality, we do not know how this invisible hands work.

            But we are again reminded of the manipulators, the dollar salters (the Binondo Central Bank), and those few Filipinos who deposit billions of dollars in the Swiss banks. We are reminded of those short-term foreign investors, who come and appear here to invest in our money market, but also suddenly disappear together with their dollars at the slightest disturbance of our social and political order, or even on the basis of some grim speculations. We are at the mercy of these "invisible hands" having brought us to what we are experiencing now in Asia.

            The level of supply is not so much the issue per se as the rate it is kept circulating in the market. Money kept at home has no immediate value, except for future use. It contributes nothing to the economy. But put to circulation, it can be used as capital for productive investments, thus, contributing to the growth and stability of the economy. The more money is circulated in the market and used for capital investments, the more the economy grows and the more the economy becomes alive and vibrant.

            Because of this, another concern of the quantity theory of money is how to influence the rate of money circulation in the market. Economists encourage people to save their money in the banks or to invest their money in economically productive business undertakings. Money saved in the banks means ever-ready capital available anytime for productive use; it is "stand-by" capital, ready to be harnessed in case of expected and unexpected changes in the market. The more money is saved in the banks, the more available capital is accumulated, the more capital is available to investors; and when harnessed for productive undertakings, it means more production, more employment, and more income.

            In turn, more income to the family means better education, improved skills, more amenities, more opportunity to travel and take a vacation, more time and peace of mind to devote to religious and spiritual activities, etc. It also means more freedom and greater opportunity for the individual and the family to directly participate in shaping the events that take place at home, at work, in the community, and in society as a whole. Does this not bring satisfaction, happiness, fulfillment, and joy to the individual and the family?

            The main proponents of the velocity aspect of money supply models are Milton Friedman, Karl Brunner, Allan Metzer, and Albert Burger.

            In addition to graphs and charts, economists offer several mathematical models and measurements to determine the quantitative impact of money supply on the overall economy. These models and measurements may require the use of calculus, regression, sampling, and related mathematical measures. In monetary economics, many of these measures are intended for macro applications. Students of monetary economics spend most of their time and efforts understanding these theories, models, and measurements with the view of applying these in their thesis, dissertation, and later in their place of work. They will be lucky, or course, if they will be able to land a job in such financial institutions as the Central Bank, Budget and Management, Finance, or in international financial institutions like the International Monetary Fund (IMF), World Bank (WB), and the Asian Development Bank (ADB).



            AT THIS JUNCTURE, let us pause and reflect.

            The students should by now be realizing the serious limitations that monetary economics offers to the nation and the people as a whole. In our excursus into the history of its development, we have seen that money is not only a continuing economic cycle of acquisition, consumption, production, and so on. It is also a cycle of deprivation, a cycle of unfulfilled needs and desires, a cycle of mental anguish, pain, suffering, and so on. For the producers, investors, and capitalists, money is a cycle of wealth and affluence; for the poor consumers, it is a cycle of agony and misery.

            While the reasons for holding cash money may apply to corporations and individuals as well, the demand theory for money is not very clear on the issue of how much money each individual or family should hold. We only see in reality that some people hold great amount of cash money and even amass themselves with enormous wealth, while others are not able to hold any money at all.

            Demand theorists are silent on the meaning of demand. Whether demand is triggered because of needs or wants and desires, or still whether it is a demand only by the individual or society, the theory does not say anything on this. The theory does not care whether the demand for money is coming from the urban poor, farmers, and workers or from the wealthy.

            The theory also does not say anything about how to satisfy the demand of individuals and their families. It might be expecting too much from the theory, but is it not more beneficial to the people if a supplementary theory be designed to address the issues we have just raised?

            One also notes that the monetarists are only concerned of economic variables (investments, production, employment, prices, productivity), and not of non-economic, non-measurable, non-quantifiable variables. In addition, the concern of monetarists is too much focused on the macro level or on the national economy. This is understandable since its impact on the individual and the family can be disastrous when prices start to rise, when it is getting hard to land a job after graduation, or when one is laid off and terminated, and so on.

            It goes without saying that the quantity theory of money is not concerned of the family, much less the ordinary man. It would be very interesting if a quantity theory of money were to be developed from the individual's point of view.

            Finally, the concern of economists about the circulation of money is commendable. Money has to circulate smoothly and regularly to give life to the people and to all the sectors of the economy. McLaughlin and Davidson point out that this "unimpeded flow is the key to economic health" (1994:337). But there is something amiss. Money circulates only among a few at the top who are rich, famous, and powerful. Many economists hold the view that the pie needs to be enlarged first before talking of sharing and equity. "Why is this so?," "Why do the people always bear the greater costs, sacrifices, and burden?" the ordinary worker asks.

            The quantity theory of money and even the money market are not concerned of this question. The theory does not touch on the sharing aspect of the circulation, what it is mainly concerned of is the level of money supply available at the macro level and as long as money is used productively, then, the economy and for that matter the people is monetarily sound.

            In the end, it is tempting to point our fingers at somebody. Economists and monetarists are busy arguing how to measure and control the money supply, offering numerous measures and definitions. Yet, we can ask with Davies why a particular monetary theory enjoys a vogue, then, give way to an opposing theory which in turn is displaced by a theory similar to its predecessor?

            However, rather than blame economists who are simply doing their work---and they are doing their role expertly, I see this as a challenge to non-economists, especially to cosmic anthropologists, psychologists, sociologists, etc. to be more aggressive in confronting the non-economic aspect of money in their research and studies.