Monetary Theory Research Paper Starter

Monetary Theory

Monetary theory explores the root economic causes shaping the demand for currency. The amount of money in circulation at any given moment, some contend, is largely determined by total spending across the economy. Because the speed at which this money changes hands rarely changes and there's a lead-time involved in more goods and services, increasing the money supply only causes inflation. Another major school of thought emphasizes individual preference in the use of money as the major determinant. Consequently, the money supply, output, prices and the rate at which money is spent can all fluctuate over time. Third theory views money as really just another commodity and demand for it is subject to supply, prices, inflation and preference for substitutes.

Keywords Equation of Exchange; Exchange Currency; Fiat Currency; Inflation; Marginal Productivity of Capital; Monetary Stock; Monetary Theory; Money Stock; Precautionary Demand for Money; Quantity Theory; Real vs. Nominal Value of Money; Specie; Speculative Demand for Money.; Transaction Demand for Money; Velocity of Money

Economics: Monetary Theory


Its symbols vary — $, £, €, ¥ — but they all identify the most useful device ever created: Money. Just how useful it is becomes painfully clear when you don't have any; then nothing else matters but acquiring some. To get anything of economic value, we must be prepared to give something of like value. In-kind exchanges of tangible goods or services involve the transfer of readily apparent value. However, barter on a large scale isn't very efficient. Bulk items are too cumbersome and the demand for most specialty items too sporadic to trade either with enough frequency to stimulate economic growth. Money solves this problem rather ingeniously: By design, it's a very portable substitute for all kinds of barter. It also assigns value. Every good and service, you see, has a particular worth relative to every other good and service. Using money as a standard unit of account permits us to represent this relative worth numerically as a price. The fact that virtually everything can be assigned a price makes money a universal medium of exchange (Zijlstra, 1979).

In all, then, money may well be the most versatile tool every invented. Its adoption and use proved instrumental to the economic specialization and division of labor that sped the production of an ever widening number of goods (Clever, 2002). Just as its concentration and use as investment capital made the industrial revolution possible. These historical facts along with money's utter centrality to modern economic life, have led economists for some time now to wonder what, if any, the exact relationship might be between the supply of available money and the amount of aggregate demand and output. Their reasoned conclusions collectively make up what's known as Monetary Theory. Arestis and Mihailov (2011) define monetary theory as “rationalizing and microfounding money itself as well as its demand by economic agents” (p. 772). On the whole, it is a fairly abstract body of work that explores a very historical phenomenon, so our surest route to understanding the essentials of the former lies in reprising the major developments of the latter first.

A Brief History of Money

For centuries, gold and silver cast along with baser metals into coins physically stored a set amount of value. Their scarcity made them 'precious' metals ideally-suited to the task, just as the widespread need for a food preservative made salt a much earlier form of 'exchange currency.' Crucially, both could be easily divided into smaller portions when the need arose. More to the point, perhaps, each was scarce and widely in demand; as such, each made for viable medium of exchange. Population growth and economic expansion, however, increases demand for currency, straining the available supply of the scarcer forms of exchange currency like gold and silver. When this happened, royal mints diluted the silver content per coin to put more in circulation. But the population's valuation of goods and services remained largely unchanged. It thus took more of the debased coins to provide the same amount of gold or silver as before, effectively driving up prices.

In the quantities needed for large transactions, what's more, silver coins were bulky and heavy; bars of gold bulkier and heavier. One way around the problem was to leave precious metals with a trustworthy party who in return would issue a certificate of ownership redeemable at anytime. The practice dates back to the goldsmiths of medieval times; the distant forerunners of today's commercial banks. Traveling merchants found they could often pay for goods with the certificates themselves. Commercial banks in the 18th century followed suite on a much wider scale, issuing promissory notes with face values redeemable by the bearer in gold or silver coins from their vaults. Bankers were pleased to discover most bearers were just as content conducting transactions solely via these notes, so banks as a rule had only to keep enough gold and silver on hand to cover a portion of the notes it had issued.

Yet, any transaction made with these notes was in the final analysis an act of faith on the part of buyer and seller. The notes themselves had to be genuine, the buyer had to have purchased them via a deposit at the issuing bank and the bank itself had to be able to convert the note into gold or silver on demand. Banks with trustworthy reputations and very large asset and customer bases helped popularize the concept of a paper currency. Over time, though, problems arose that forced changes. 'Bank notes' could be counterfeited much more easily than coinage. As much as a third of all the early bank notes circulating in the United States were forgeries. Any bank or merchant could issue its own paper currency. In fact, well over a thousand did in the United States in prior to the reforms of 1861.

With so many different sizes, colors and designs of 'bank notes' passing through their hands, it's little wonder consumers and shopkeepers alike remained skeptical about its value. The only effective way to end this chaos was to make a national government or a single bank of its choosing the sole issuer. By the second half of the 19th century, this responsibility fell to the U.S. Treasury Department, to the Bank of England, the U.K.'s largest private bank, and a semi-autonomous central bank in Japan. Each, significantly, stockpiled the necessary reserves of precious metals to redeem any bank note it issued. Other countries followed suit and, within decades, the base value of most currencies was set by assigning each an equivalent fixed weight in gold; greatly facilitating trade between nations.

Eventually, though, the amount of currency required to sustain the growing volume of cash transactions surpassed the world's stock of gold and silver. A continued preference for a commodity-backed currency was no longer economically tenable. As populations rose, a fixed money stock would invariably lead to disinflation and a reemergence of barter exchanges on a large scale and overall economic activity would suffer. The only solution lay in a 'fiat' currency. Here, essentially, the government declares a currency to be 'legal tender.' Its base value equals the amount of physical goods it can be exchanged for at the point in time when the public comes to accept and believe this assertion. From then on, monetary authorities expand or contract the money supply to maintain this common perception of its nominal value. As a medium of exchange, it works because we all willingly suspend our disbelief. In the final analysis, though, it's just paper or, in the case of demand-deposit checking accounts, entries in a bank ledger.


All monetary theory flows from two key concepts: The money stock and the velocity of money.

  • The money stock is the sum of all the coin, currency and demand-deposit funds in circulation along with the vault cash held by banks and, in the last...

(The entire section is 3531 words.)