According to the followers of the equation of exchange, the price level directly and proportionately depends upon quantity of money. But price level is inversely related to the value of money. Hence value of money is inversely proportional to the quantity of money. Money is general purchasing power. Therefore the capacity of a unit of money to purchase more or less goods will depend upon the level of prices. By way of example if the price of chocolates is 20 cents per piece then a dollar can purchase 5 chocolates but if its price rises to 25 cents per piece the same dollar can purchase only 4 pieces of chocolates. Therefore with the rise in the price, the value of the dollar falls. Similarly with a fall in the price level, the value of the currency rises. We can relate this to the variations in the quantity of money.
Increase in M ® Rise in P ® Fall in value of M
Decrease in M ® Fall in P ® Rise in value of M
This relationship forms the basis of the monetary policy.
(C) Monetary Management: Monetary authority in the form of the central bank and some government agency together control money supply. Monetary management is either to expand or contract supply of currency and credit from time to time according to the needs of the economy. For this purpose the central bank can employ both quantitative and qualitative measures.
Quantitative control occurs in the form of:
- Variable Reserve Ratios (VRR),
- Open Market operations (OMO) and
- Bank Rate (BR) or Discount Rate.
The central bank can use one or all the three measures as the situation may demand. If the central bank proposes to follow cheap money or expansionary policy then it can either reduce reserve ratio requirement (say from 10 to 8 percent), or buy the securities from banks and individuals, or reduce the bank rate or introduce all the three measures. By reducing RR i.e. the reserve requirement of commercial banks, their capacity to create credit increases. By buying the securities or bonds, the central bank puts more money in the hands of people and bankers. This helps in the expansion of credit. A fall in the Bank Rate makes central bank assistance cheaper. The bankers are therefore induced to borrow more from the central bank and supply more credit. The rate of interest charged by bankers also falls, as it is related to the bank rate. Therefore investment demand for bank credit increases.
In the opposite case, the central bank can undertake exactly contrary measures to contract the credit supply. It can increase reserves requirement, sell the securities and raise the bank rate. All these steps reduce capacity of the bankers to supply credit and also make credit resources dearer. Therefore investors’ demand for bank credit tends to fall. During periods of inflation when price level is rising sharply the central bank follows a contractionary policy. However, during periods of deflation when price level is low and declining and output and employment levels are below full employment capacity, the central bank follows expansionary policy.