Question

ECB changing stance

The main objective of the European Central Bank (ECB) is to maintain inflation in the euro area at below 2 percent to achieve this strategy of price stability; it follows a two-pillar analytical approach to assess the risks to price stability and its monetary policy actions: the economic analysis and the monetary analysis. The monetary pillar, which makes use of the quantity theory of money, was heavily criticized by many in that it was not relevant to monetary policy decisions. In November 2013, a paper published by the ECB itself casted doubt on the effectiveness of the quantity theory of money stating that countries with moderate or low inflation don’t fit this theory.

9. What is implied by this news clip about the ECB’s position prior to 2013 about the velocity of circulation, the equation of exchange, and the quantity theory of money?

10. What is implied by this news clip and the ECB paper about both the position of the critics of the ECB’s use of monetary analysis and the ECB’s position after 2013 concerning the velocity of circulation, the equation of exchange, and the quantity theory of money?

Answer 1

9. The main objective of European Central Bank (ECB) is to maintain inflation in the euro area at below 2 percent. Prior to 2013 the European central Bank used to believe quantity theory of money.

Quantity theory of money states that there is a direct relation between the quantity of money operating in an economy and the level of price of goods and services in the economy. According to the theory if the quantity of money is doubled, the price of goods and services also doubled in the economy.

In other word we can say that an increase in supply of money increase capabily of buying for consumers and decreases marginal value of money. Hence it causes increase in price of goods and services (inflation) to compensate the decrease in margnal value of money.

Quantity theory of money can be described by a simple equation:

MV = PT

M - Money supply

V - Velocity of transaction

P - Average Price level

T - Volume of transaction of goods and services

It can be derived bby the equation of exchange:

Tot al spending = M * VC

M - Money supply

VC - Velocity of money

Prior to 2013 ECB used to think that an increase in money supply in the economy can cause an increase in price level in the economy. Hence an increase in money supply can be helpful to maintain a moderate inflatio of 2% in the economy. And when the inflation rate may go to an alarming stage, a cut in money supply in the economy by monetary policy of the government can bring stability in the economy.

10. In November 2013, ECB released a paper in which it doubted on the effectiveness of quantity theory of money. ECB must have seen in its paper that Quantity theory of money lacks to describe the acctual reason of inflation in the economy. It lacks in many aspects:

• Quantity theory of money states us that the total amount of money spent by buyers is equal to the total amount of money received by sellers. It does not tell anything about price.
• Professor Fisher made some unreal assumption in this theory. He assumed full employment of resources and expenditure stability. It assumes that other variables like V, M, T remain constant. But im reality it is seen that velocity of money changes directly proportionately with the change in production.
• It is unable to explain the reversal trend of trade cycle i.e. the interaction made in an economy when it reaches to the bottom of slump in the trade cycle.
• The theory is helpful in long run phenomenon but it is not fit in short run.
• It does not describe the relation between M and P. It can not explain the price level what causes the change in price level.
• Theory makes a big mistake by considering money only as a medium of exchange. It does not consider money as a store of value. In simple term we can say it igneores the tendency of people to save for future. It does not take savings in consideration. It assumes that people spend whole amount of money they receive.
• The theory makes an undue emphasys on the quantity of money. It assumes that quantity of money is the only determinant of price level. Though Keynes state that price level deends on several other factors like income, expenditure, investment, savings etc.
• The quantity theory of money is assumed to occur in a static environment where al the other factors remain constant. Hence it is not appropriate for the dynamic world.

On the basis of the above mentioned reasons ECB as well as the critics state that Quantity theory of money is mot appropriate for an economy with moderate or low inflation It is never useful to maintain a low level of inflation (2%) in the economy.