The Quantity Theory of Money:

People have a demand for money simply as they have a demand for any other good. They desire to hold a certain amount of wealth in the form of readily-spendable purchasing power for the reason that the stuff is useful. The additional money in your portfolio, the easier it is to purchase things. Too small money makes living one's life pointlessly difficult. You have to spend time running to the bank for extra cash or waste energy and time liquidating pieces of your portfolio prior to you can carry out your normal daily transactions.

Alternatively you don't want to have too much of your wealth in the form of readily-spendable purchasing power. Cash sitting in your pocket isn’t earning interest at the bank. Wealth you will not desire to spend for five years could earn a higher return as a certificate of deposit or invested in the stock market than sitting in your checking account.

Figure: Reasons for and Opportunity Cost of Holding Money

Legend: As with each other economic decision, the amount of wealth households as well as businesses wish to hold in the readily-spendable form of money depends on the benefits of holding money and the opportunity cost—the lost interest and profits—of doing so.

The theory that the only significant determinant of the demand for money is the flow of spending is called the quantity theory of money. It is recapitulated in either the Cambridge (England) money-demand function:

M = (1/V) x (P x Y)

Or in the (American) quantity equation:

M x v = P x Y

In whichever form of the quantity theory, P x Y represents the total small flow of spending. For every dollar of spending on households and goods and services want to hold 1/V dollars worth of money. The parameter V—a constant or else perhaps growing slowly and predictably trend--is the velocity of money. The speed of money is a measure of how "fast" money moves through the economy: how several times a year the average unit of money shows up in someone's income as well as is then used in to buy a final good or service that counts in GDP.

Therefore if we know the velocity of money V, real GDP Y and the money stock M we can calculate that the price level is:

P = (V/Y) x M
     
Must the price level be momentarily higher than the quantity equation predicts, households as well as businesses will notice that they have less wealth in the form of readily-spendable purchasing power than they wish. They will cut back on purchases for a small while to build up their liquidity. As they cut back on sellers, purchases will note that demand is weak and cut their prices, therefore the price level will fall.
 
In the United States the Federal Reserve the nation's central bank that figure out the money stock. That is the basic job of monetary policy- the determination of the money stock.

The central bank directly figures out the monetary base, the total of currency in circulation and of deposits at the Federal Reserve’s twelve branches. When the central bank wants to decrease the monetary base it sells short-term government bonds and accepts currency or deposits at its regional branches as payment. The currency is subsequently removed from circulation and stored in a basement somewhere, the deposits it receives as payment are then remove from its books. Therefore the monetary base declines. When the Federal Reserve wants to raise the monetary base it buys short-term government bonds, paying for them with currency or else by crediting the seller with a deposit at the Federal Reserve. These transactions are described as open-market operations, for the reason that the Federal Reserve buys or sells bonds on the open market. The procedures that govern when and how the U.S. the Federal Reserve, central bank, undertakes these transactions are decided at periodic meetings of the Federal Reserve Open Market Committee [FOMC].
   
Open Market Operations:

Legend: The Federal Reserve controls the funds supply through open market operations purchases and sales of bonds on the open market. Purchases of bonds raise the economy’s money stock. A sale of bonds consumes cash out of the economy and reduces the money stock.

The Federal Reserve straightly controls the monetary base. The other actions of the money stock are figured out by the interaction of the monetary base with the banking sector. Banks accept checking as well as savings account deposits. They loan out the buying power deposited in the bank earn interest and provide the depositor with a claim to wealth in readily-spendable form. However central banks limit commercial banks' ability to accept deposits. Central banks necessitate that commercial banks redeposit at the Federal Reserve a certain proportion of their total deposits. Financial institutions as well find it prudent to hold extra liquid reserves in case an unexpectedly large number of depositors seek to withdraw their money. There is nothing inferior for a financial institution than for it to be unable to meet its depositors' demands for money. Therefore as Box 8.2 demonstrates broader measures of the money stock are larger than but limited in their growth by the size of the monetary base the regulatory reserve requirements imposed on banks and other financial institutions; along with financial institutions' extremely powerful incentive never to get caught with no the cash to satisfy depositors' demands.

Details: Different Definitions of the Money Stock

The diverse definitions of the money stock all draw the line separating ‘money’ from ‘not-money’ in different places. Economists’ definition of ‘money’ considers any assets held in the form of readily-spendable purchasing power to be money. However ready spend ability is to some degree at slightest a thing found in the eye of the beholder.

The narrowest meaning of money—called ‘H’ for ‘High-Powered ‘Money’ or sometimes B for Monetary Base—includes only cash as well as deposits at branches of the Federal Reserve. The assets that make up the financial base are special because only they can serve as reserves to satisfy the Federal Reserve’s requirement those institutions that accept deposits as well maintain funds to cover any emergency spike in withdrawals.

The narrowest usually used definition of money is M1, which contains currency plus checking-account deposits, traveler’s checks and any other deposits where the depositor can demand his or her money back as well as get it instantaneously from the bank. Almost anyone will accept M1-type money as a signifies of payment for almost any purchase. M2 adds to M1 wealth detained in the form of savings accounts, wealth held in comparatively small term deposits, as well as money held in money-market mutual funds. A few of the money included in M2 cannot be spent without paying a penalty for early withdrawal. Moreover if the bank wishes it has the legal right to impediment your withdrawal for a period of time. M2-type money is a dash less spendable than M1-type money.

There are still broader meanings of money. One of the broadest is M3 which comprises large term deposits and institutional money-market fund balances. Still larger is L which comprises savings bonds and Treasury bills. However a large chunk of these assets are not readily spendable by any stretch. Have you ever tried to purchase something with a savings bond, or a Treasury bill?

The quantity equation:

P = (V/Y) x M

Leads instantly to an equation for the inflation rate π--the proportional rate-of-change of the price level if you recall our rule from previous chapter about how to compute the proportional growth rates of products or quotients. Put merely the proportional growth rate of a product is the sum of the growth rates of the terms multiplied together the proportional growth rate of a quotient is the dissimilarity between the growth rates of the individual terms. Thus:

(Inflation) = (velocity growth rate) + (money growth rate) - (real GDP growth rate)

To write this relationship in additionally compact form, use a lower-case m as well as a lower-case v for the proportional growth rates of the money stock and velocity, and utilization a lower-case y for the growth rate of real GDP. Then:

π = m + v - y

If the relative growth rate of real GDP is 4% per year the velocity of money V increases at a proportional rate of 2% per year, in addition to the money stock M grows at 5% per year then:

π = 5% + 2% - 4% = 3%

The inflation rate is three percent per year.

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