2.2 Financial activity and the level of aggregate demand

2.2Financial activity and the level of aggregate demand

We have just seen how activity in the real economy requires the development of a

nancial system enabling units (or sectors) with a nancial surplus to ‘dispose’ of

that surplus by lending it. By lending, the surplus sector acquires nancial assets. As

we saw in Chapter 1, these assets have varying degrees of liquidity. At one extreme,

we have just seen (Table 2.2) that surplus units could acquire notes and coin and bank

deposits. In any economy, this amounts to acquiring ‘money’. Towards the other

extreme (again see Table 2.2), they could add to their holdings in mutual funds. These

are certainly not money, but they can be sold back to the mutual fund company very

quickly. (Compared with ‘real’ assets such as land, buildings and consumer durables,

therefore, all nancial assets could be considered comparativelyliquid.)

There are at least three ways in which nancial developments could affect the level

of aggregate demand. The rst two involve the creation of liquid assets (including

money); the third involves changes in people’s nancial wealth.

Aggregate demand: The total level of spending in the economy on newly produced

goods and services in a given period of time.

As we saw in Chapter 1, one effect of a nancial system is to create liquid assets,

and it has long been thought that the level of liquidity in an economy has some

effect on the level of spending. If this is true, we might consider the hypothesis that

an increase in nancial activity causes a rise in spending. There are two distinct

channels through which this might happen; which matters most has been a matter of

controversy between economists for many years. On the one hand, there is the view

that it is the expansion of monetary assets(bank and building society deposits) that

is responsible for the extra spending. This view has often been labelled ‘monetarism’

and was particularly inuential in the UK in the 1980s. The alternative view says

that the increase in liquid assets of any kindwill do the trick, since by denition any

liquid asset can be quickly converted to money. This proposition is often associated

with the name of J M Keynes and certainly was widely held among economists who

followed Keynes in the 1950s and 1960s. We can explore both channels by using the

‘equation of exchange’, although the equation itself is usually regarded as a building

block in monetarist theory.

2.2.1

Money and spending The equation of exchange says:

MsV ≡PY

(2.3)

where Msstands for the total stock of money, Pis the general or average level of

prices of newly produced goods and services, and Yis the volume of goods and ser-

vices produced. Note, therefore, that PYis total output valued at market prices. Vis

given the name ‘velocity’ and is sometimes said to describe the frequency or speed

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Chapter 2 • The nancial system and the real economy

with which money changes hands. In a modern system where money is largely bank

deposits, ‘changing hands’ is a difcult idea to visualise. It may be better just to

think of it as that gure or coefcient which allows the current money stock to be

sufcient to buy this year’s total output at market prices. Thus:

V≡PY/Ms

(2.4)

Note that we have written the equation using ≡rather than . This is because it

is an ‘identity’. It is true by denition. We make it so by dening PYas the value of

output sold and then saying that MsVis the quantity of money timesthe ‘number

of times it changes hands’. In doing that we have just made MsV stand for total

spending, and since spending requires something to be bought (i.e. sold), both sides

mustbe equal. No one would argue with this. Since it is true by denition, there is

nothing to argue about.

Velocity (of circulation):A ratio (PY/Ms) which expresses the relationship between the

quantity of money in circulation in the economy and the value of total output.

However, the equation can be turned into a theory (which allows us to talk about

directions of causation and to make predictions) by making some assumptions. If

we make the following assumptions, we have turned the equation into part of the

theory of ‘monetarism’. As we said above, this is controversial.

l	Vand Ychange only very slowly. (In the simplest case, Vand Yare xed.)
l	Msis determined by variables outside the identity – perhaps by the government, or central bank, or even the nancial system itself.

Using these assumptions we can make a case for the rst channel of inuence upon

aggregate demand. This is because the assumptions make money into an independent

variable whose effects are predictable and mustfall upon the price level. Box 2.1 shows

what happens when the money stock (Ms) expands by 10 per cent when output is

increasing at only 2 per cent.

Box 2.1

The quantity theory of money

If by denition MsV≡PY, then if we turn the variables into growth rates it follows that:

MsVpY

If we specify the behaviour of V(let it grow very slowly at 1 per cent) and Y(assume it

grows at 2 per cent), we have a theory which allows us to predict the effect of changes

in Ms. Suppose, for example, that Ms grows at 10 per cent, then we have:

0.1 0.01 P0.02

Rearranging gives us

P0.1 0.01 0.02 0.09

an ination rate of 9 per cent p.a.

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