VALUE OF MONEY AND PRICE LEVEL

Value of money 

  • “It is the quantity of goods and services a unit of money can buy in a given period”.
  • In other words, the value of money refers to the purchasing power of money.

If a unit of money can buy a larger quantity of goods than before, it means that its value has risen or gone up. But if a unit of money can only buy a fewer quantity of goods than before, it means that its value has fallen or come down.

For instance, in 1970, N5.00 could buy a basket of rice. But in 1990, N5.00 could only buy a cup of rice (i.e. one twentieth of a basket of rice). This implies that the value of money has fallen. Conversely, if in 1990 N5.00 could buy two or more baskets, it implies that the purchasing power of money has gone up.

The above implies that ‘value of money depends mainly on the general price level’. A rise in price level (prices) makes the value of money to fall, and vice versa.

Note that “value of money” and “purchasing power of money” are synonymous phrases; thus they are used interchangeably. That is, they mean the same thing. The purchasing power of money is the quantity of goods a unit of money can buy in a particular period.

 

Factors influencing value of money

  1. Price level: Money value is mainly influenced by the general price level. A rise in the price level causes a fall in the value of money as a unit of money can only buy a fewer quantity of goods than before. While a fall in the price level raises the value of money as a unit of money can now buy a larger quantity of goods and services than before.
  2. Supply of money: An increase in supply of money, all things being equal, i.e. total output of goods is constant, causes a rise in prices. And this leads to a fall in value of money. If supply of money decreases, there will be a rise in value of money as a unit of money can buy a larger quantity of goods than before.
  3. Demand for money: An increase in demand for money by everybody raises level of demand and that of the price level. This causes a fall in the value of money. While a decrease in demand for money causes a rise in the value of money as it leads to a fall in price level.
  4. Level of output of goods and services: A rise in total output of goods and services in a country, all things being equal, i.e. money supply is constant, makes a unit of money to buy a larger quantity of goods than before. This causes a rise in value of money. On the other hand, a fall in total output of goods while supply of money is constant, makes a unit of money to buy a fewer quantity of goods than before. And it causes a fall in value of money. Briefly, a rise in output of goods causes a rise in value of money, and vice versa.
  5. Business cycle – Inflation and Deflation: During inflationary period, business boom, there is a rise in the general price level. This causes a fall in value of money. While during deflationary period business slump, there is a great fall in the general price level. This makes value of money to rise. Figure 5 given below illustrates business cycle.

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Effects of a change in value of money

  1. On fixed income – Salary earners (workers): A rise in value of money leads to a rise in real income of people whose incomes are fixed. While a fall in money value causes a fall in their real incomes as their incomes can only afford them a fewer quantity of goods and services than before.
  2. On loans – borrowed money (debtors and creditors): A rise in price level causes a fall in value of money and it causes a fall in value of loans in real terms . Thus debtors pay less in real terms to creditors than the amount they borrowed. That is, the present value of the loan is less than its previous value in’ real terms. Thus debtors gain at the expense of creditors, and vice versa.
  3. On non-fixed income profits’ earners (businessmen, e.g. traders, contractors, etc): A rise in prices which causes a fall in value of money leads to a rise in level of profit – increase in non-fixed incomes, e.g. profits’ earners like business men, traders, etc. While a fall in the general price level (increase in value of money) causes a fall in their incomes.
  4. On employment – job seekers (applicants): Level of employment is usually high during the period of a fall in the value of money (increase in prices). And a rise in value of money (decrease in price) brings about a high level of unemployment. Thus value of money has inverse relationship with level of employment.

 

Price Level

What is a price?

“A price is an exchange value of commodity expressed in monetary unit.

What is general price level?

“General price level or price level is the average price of all goods and services”

We recall that an increase in prices makes a unit of money to buy a fewer quantity of goods than before; while a fall in prices makes a unit of money to buy a larger quantity of goods than before. This indicates that a rise in the price level leads to a fall in the value of money as a unit of money can only acquire a fewer quantity of goods than before. While a fall, in general price level indicates a rise in the value of money as a unit of money can be exchanged for a larger quantity of goods than before. This reveals that:

“value of money has inverse relationship with the general price-level”.

Thus value of money is measured by the Price level or Price index number. It clearly indicates that “Value of Money (VM) has inverse relationship with General Price Level (GPL)”. That is, if prices increase, value of money decreases and vice versa. And if GPL is constant VM is also constant.

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Business Cycle 

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Point A

Boom or Peak: It refers to the highest period of economic prosperity. It is characterized by excess demand, high velocity of circulation of money unit (naira), increasing prices, maximum profit and a great fall in the value of money.

 

Point B

Recession: It refers to the beginning of economic contraction. It is a period that witnesses a slight fall in prices due to declining demand.

 

Point C

Depression: It refers to a long period of severe economic contraction. It is characterized by a great fall in prices due to lack of demand.

 

Point D

Slump: It refers to the lowest level of economic activity – a period of severest economic contraction or worst economic period in an economy. It is characterized by a total fall for almost all goods and services. The period witnesses the highest level of unemployment which is referred to as ‘cyclical unemployment‘. The general price level is at its lowest ebb (level), and value of money is at its peak. Thus businessmen are quite pessimistic about the future; and investment is at its lowest level even though capital is free because of the anticipated heavy losses.

 

Point E

Recovery: It is a period of economic expansion. Business activities are picking up; that is, it is the beginning of economic prosperity. It is characterized by entry of numerous investors into the industries, rising prices and existence of abnormal profit. Thus business men are quite optimistic about the future.

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