Follow by Email

Wednesday, 16 November 2011

The Quantity Theory of Money

The quantity theory of money

·       Explains that a rise in the money supply leads to excess demand, leading to a rise in prices, inflation. To put it simply, too much money chasing too few goods.

·       The quantity theory is a special case of demand pull inflation.

·       The Fisher Equation of Exchange provides evidence for the quantity theory of money.

M = money supply               
The total amount of money in circulation in the economy at any given time.

V = velocity
The number of times the money circulates around the economy at any given time. V is influenced by methods of payments such as cash, bank overdrafts, credit or debit. Methods of payments are limited therefore V remains constant.

P = price level

T = total transactions
The measure of all the purchases of goods and services in the economy. T remains constant because the theory assumes money is a medium of exchange, not a store of value, therefore people spend quickly any money they receive.
If V and T remain constant, they cancel each other out and thus a M = P. This means that a rise in M will create a rise in P, therefore explaining the theory.

Keynesians generally reject the theory because….

1. There are too many assumptions that the theory relies upon. They don’t believe that people quickly spend any money they receive. Instead, people hold money balances if share prices/bonds are likely to fall for example, thus V and T cannot remain constant.

2.  If there is spare capacity in the economy, Keynesians believe that real output and employment will increase, not the price level. However a counter-argument for that would be the Phillips Curve (more on that to come!).

3. If M has increased, the effect it can have on P is limited if V balances out the increase in P. Reflation of the economy can further limit the effect of a rising money supply on the price level.

4. Reverse causation: Inflation causes an increase in the money supply, not the other way round. Cost push inflation occurs and the money supply adapts (by rising) to finance a higher price level set for consumers to pay.

Normal Good

A normal good is one where, as incomes rise, demand for the good rises. For example, my demand for clothes and shoes would rise if my income rose.

In contrast to a normal good, is an inferior good, where notes on that can be found here.

Trade Unions

A collective association of workers whose aim is to improve the pay and conditions of member workers.

Aim to:
·     Improve real incomes
·     Working conditions
·     Pensions
·     Security
·     Unfair dismissal
·     Counter monopsony power
·     Protect against discrimination

Trade union membership has declined to less than 30% of all those employed in the UK (2007). Reasons for this include:

·     Membership is considered to be a waste since the economy was in a boom creating less of a need to bargain for higher wages

·     Tougher employment laws

·     Little evidence for significant mark-ups in wage levels bought about by trade unions

·     You become less employable if you belong to a trade union

·     Changes to the labour market: decline in jobs in heavy industry to more service sector based, shifts towards shorter employment contracts and more people working part-time/flexible hours

·     Some employers restricted trade unions in their work place

Unions influence pay by:

Ø     Collective bargaining
o      negotiate pay levels above the current levels that exist. This is only effective if the union has control over the total labour supply available in the industry.
Ø     Closed shop agreementemployer and union agree that all workers be part of the union
o      Pre-entry: workers must join the union before starting employment
o      Post-entry: non trade union members get the job but have to join to keep the job. This prevents free-riders benefiting from the mark up bought by the union on wages
o      This was considered to be a labour restrictive practice and is now illegal in the UK

Pre-entry closed shop

The diagram below briefly displays a pre-entry closed shop agreement made by unions.

S1 shows the supply for labour in the market before the closed shop agreement. Supply shifts to the left and becomes more inelastic because the increase in wages has minimal effect on employment if the workers have already been employed by the firm. Employment still, however, falls from L1 to L2 when wages rise from W1 to W2.

Perfectly competitive market

To refresh your memory of the PC market, click on the revision notes of the PC market in the short run and long run.

This diagram shows the effects of a trade union in a perfectly competitive market. The equilibrium wage rate is W1 where the number of workers employed is L1. The effect of the trade union is that wages are pushed up to W2 à the acceptable wage rate for union members. The supply curve becomes W2XS. From W2X, the supply curve is perfectly elastic. Along XS, the curve is upwards sloping because more workers are attracted to higher wage rates. The employer wishes to hire L3 workers but the number of workers willing to work at the wage rate of W2 is L2. Thus there is excess supply of labour, causing classical unemployment between L2- L3

This diagram argues that the trade union causes unemployment, however one can counter-argue, as in the Keynesian view. It is unrealistic to assume that demand conditions remain unchanged because higher wages would normally increase demand for output, thus increasing output and increasing demand for workers to produce more output.

This diagram can also be used to explain the effect of the National Minimum Wage, as well as trade union mark-ups.

Look out for more on the effects of trade unions in a monopsonistic market soon! (To prepare yourself, you could read Word of the Day)