7.2 Monetary Policy

(A) Equation of Exchange: Monetary policy, like fiscal policy, can also be used either as an alternative or a complementary measure. It can be used for its expansionary or contractionary effects. The classical economists would rely more on the monetary policy. This is because it operates only indirectly and helps to avoid direct intervention of the public authority in economic activities. But before we go on to analyze monetary policy, it would not be out of context to consider the equation of exchange.

In the early present century Sir Irving Fisher introduced an equation of exchange. This briefly summarizes classical position in this respect. The equation of exchange can be stated as :

MV = PT
or
MV = PY

There are four terms in the equation; two each on the left and right sides.

On the left hand side of the equation we have total supply of money which is M multiplied by V. The letter M stands for total quantity of money in the form of coins and currency issued by the central bank as the supreme monetary agency. However, total supply of money is much larger than this because each unit of money is transferable and capable of changing hands frequently. The total function of money supply as a medium of exchange therefore will depend upon the average number of times a unit changes hands. This is called velocity or frequency of using money units. Let’s illustrate this: if an individual consumer starts off with a currency note of $10 in the morning, he may spend it on purchasing sugar. The sugar merchant later on may purchase fruit against the same bill. The fruit seller in his turn may buy milk with the same note. Finally, the note rests with the milkman. During the course of the day the note of $10 has performed four exchange activities.

$10 worth sugar + $10 fruit + $10 milk + $10 income of milkman = $40. Thus a single note or quantity (M) of $10 has performed $40 worth total exchange activity which is the total supply of money. If this is divided by the quantity 'M' what we get is velocity or the average number of times a particular unit of currency has been used to purchase final goods and services over a year.

Total exchange or supply (= 40) M (the quantity = 10) = V

Normally, value of 'V' settles itself between 3 and 4. It is only during highly inflationary conditions that it moves above 4, and under deflationary conditions it falls below 3.

On the right hand side of the equation the two important terms are 'P', the average price level or index number of prices and 'T', the volume of trade or transactions. The total volume of all the goods and services is traded at the national level and hence it can also be symbolized as real national income 'Y'.