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Monetary Economics Monetary economics is a branch of economics that provides a framework for analyzing money in its functions as a medium of exchange, store of value, and unit of account. It

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considers how money, for example fiat currency, can gain acceptance purely because of its convenience as a public good. It examines the effects of monetary systems, including regulation of money and associated financial institutions and international aspects.  The discipline has historically prefigured, and remains integrally linked to, macroeconomics. Modern analysis has attempted to provide micro foundations for the demand for money and to distinguish valid nominal and real monetary relationships for micro or macro uses, including their influence on the aggregate demand for output. Its methods include deriving and testing the implications of money as a substitute for other assets and as based on explicit frictions. Traditionally, research areas in monetary economics have included: •	empirical determinants and measurement of the money supply, whether narrowly, broadly, or index-aggregated, in relation to economic activity •	debt-deflation and balance-sheet theories, which hypothesize that over-extension of credit associated with a subsequent asset-price fall generate business fluctuations through the wealth effect on net worth. and the relationship between the demand for output and the demand for money •	monetary implications of the asset-price/macroeconomic relation •	the quantity theory of money, monetarism, and the importance and stability of the relation between the money supply and interest rates, the price level, and nominal and real output of an economy. •	monetary impacts on interest rates and the term structure of interest rates •	lessons of monetary/financial history •	transmission mechanisms of monetary policy as to the macroeconomy •	the monetary/fiscal policy relationship to macroeconomic stability •	neutrality of money vs. money illusion as to a change in the money supply, price level, or inflation on output •	tests, testability, and implications of rational-expectations theory as to changes in output or inflation from monetary policy •	monetary implications of imperfect and asymmetric information and fraudulent finance[23] •	game theory as a modeling paradigm for monetary and financial institutions •	the political economy of financial regulation and monetary policy •	possible advantages of following a monetary-policy rule to avoid inefficiencies of time inconsistency from discretionary policy •	"anything that central bankers should be interested in."

Classical dichotomy In macroeconomics, the classical dichotomy refers to an idea attributed to classical and pre-Keynesian economics that real and nominal variables can be analyzed separately. To be precise, an economy exhibits the classical dichotomy if real variables such as output and real interest rates can be completely analyzed without considering what is happening to their nominal counterparts, the money value of output and the interest rate. In particular, this means that real GDP and other real variables can be determined without knowing the level of the nominal money supply or the rate of inflation. An economy exhibits the classical dichotomy if money is neutral, affecting only the price level, not real variables. The classical dichotomy was integral to the thinking of some pre-Keynesian economists ("money as a veil") as a long-run proposition and is found today in new classical theories of macroeconomics. Keynesians and monetarists reject the classical dichotomy, because they argue that prices are sticky. That is, they think prices fail to adjust in the short run, so that an increase in the money supply raises aggregate demand and thus alters real macroeconomic variables. Post-Keynesians reject the classic dichotomy as well, for different reasons, emphasizing the role of banks in creating money, as in monetary circuit theory.

Controversy in Classical Dichotomy: Don Patinkin (1954) challenged the classical dichotomy as being inconsistent, with the introduction of the 'real balance effect' of changes in the nominal money supply. The early classical writers postulated that money is inherently equivalent in value to that quantity of real goods which it can purchase. Therefore, in Walrasian terms, a monetary expansion would raise prices by an equivalent amount, with no real effects on employment or output. Patinkin postulated that this inflation could not come about without a corresponding disturbance in the goods market. As the money supply is increased, the real stock of money balances exceeds the 'ideal' level, and thus expenditure on goods is increased to re-establish the optimum balance. This raises the price level in the goods market, until the excess demand is satisfied, at the new equilibrium. He thus argued that the classical dichotomy was inconsistent, in that it did not explicitly allow for this adjustment in the goods market. Later writers (Archibald & Lipsey, 1958) argued that the dichotomy was perfectly consistent, as it did not attempt to deal with the 'dynamic' adjustment process, it merely stated the 'static' initial and final equilibria.

Mathematical representation of Classical Dichotomy: If an economy exhibits the classical dichotomy, then comparative statics analysis can be performed using a Jacobian matrix in block triangular form. That is, suppose we write where represents some exogenous shocks (changes in productivity, aggregate demand, money supply, etc., ordered so that all real shocks come first), and  represents the change in the endogenous variables (output, employment, prices, etc., again listing real variables first). Then the matrix J can be partitioned into submatrices as follows: In other words, when the classical dichotomy holds, it is possible to calculate how all the real variables change by inverting the submatrix only, thus excluding all nominal variables like money supply and prices from the analysis.

Monetary equilibrium, Classics and Keynes (Summary of the Classical Monetary theory) The monetary-equilibrium framework is in some ways not at all different from the Classical model. The three central theories of the Classical School are Say's Law, Quantity theory of money and the role of interest rates: •	Say's Law (supply creates its own demand) implies that aggregate supply would always be equal to aggregate demand. The argument was that the sales of goods in the market produces the necessary income to buy that supply. This view was a part of the belief in Laissez-faire that government intervention is not required to prevent general shortages. •	The Quantity theory of money explained the general price level whereas other microeconomic factors explained relative prices. With relative prices being explained by resources and tastes, the possibilities of shortages excluded by Say's Law and Quantity theory of money being explained by the price level, the only missing factor was the inter temporal exchange. •	In the simplest model, income Y is made up of either Consumption (C) or Saving (S) while expenditure (Yi) were either on consumption or investment goods. Here, we ignore government and foreign trade. This can be seen from equation 1. Now, if the preferences of the income earners shift towards the future resulting in a fall in C and increase in S as shown in equation 2. In the simple classical model increase in savings cause a fall in the interest rates thereby inducing additional investment expenditure. This increase in Investment (I) implies a fall in (C) on the expenditure side as shown in equation 3. As given Ci= Ce, the increase in investment is equal to the increase in savings and a shift in inter temporal preferences does not disrupt the equality between income and expenditure and also there is no change in income. (Equation4) 1. Yi = Ci + S = Ye= Ce+ I. 2. Yi = C↓+S↑ 3. Ye = Ce↓+I↑ 4. If S = I then Yi = Ye. Thus, we can see that monetary-equilibrium shares a lot with the classical model. Say's Law and Monetary equilibrium Say's Law finds its most accurate expression in monetary equilibrium. In monetary-equilibrium, production is truly the source of demand but if there is an excess demand for money this does not happen as some potential productivity has not been translated into effective demand. If there is an excess supply of money then demand comes not only from previous production but also from the possession of the excess supply. Problems with monetary-disequilibrium theory 1. According to Yeager, monetary-disequilibrium is a part of the monetarist tradition which states that "money matters the most" which cannot be true as in terms of economic analysis actors matters most. 2. The static definition of equilibrium at the heart of monetary-disequilibrium theory is flawed as he uses a very neoclassical definition on the macro-economic level i.e. he talks about constant price level. 3. Yeager does not take into consideration that business cycles start not just with monetary-disequilibrium but happens when that disequilibrium enters the market for loanable funds and produces disequilibrium there, such that the supply of lonable funds exceeds real savings.[1] 4. As the name suggests the monetary-disequilibrium theory is a strictly monetary explanation of a set of economic phenomenon. It does not take into account the real economic factors like real savings or market processes that influence business cycles.

Say's law Say's law, or the law of markets, found in classical economics, states that aggregate production necessarily creates an equal quantity of aggregate demand. Say further argued that the law of markets implies that a "general glut" (the term used in Say's time for a widespread excess of supply over demand) cannot occur. If there is a surplus of one good, there must be unmet demand for another: "If certain goods remain unsold, it is because other goods are not produced." Say's law has been one of the principal doctrines used to support the laissez-faire belief that a capitalist economy will naturally tend toward full employment and prosperity without government intervention. Over the years, at least two objections to Say's law have been raised: •	General gluts do in fact occur, particularly during recessions and depressions. •	Economic agents may collectively choose to increase the amount of money they hold, thereby reducing demand but not supply. Say's law was generally accepted throughout the 19th century, though modified to incorporate the idea of a "boom-and-bust" cycle. During the worldwide Great Depression of the 1930s, the novel theories of Keynesian economics disputed Say's conclusions. The debate between classical and Keynesian economics continues today. Scholars disagree on the surprisingly subtle question of whether it was Say who first stated the principle, but by convention, "Say's law" has been another name for the law of markets ever since John Maynard Keynes used the term in the 1930s.

History of Say's law Say's formulation Say argued that economic agents offer goods and services for sale so that they can spend the money they expect to obtain. Therefore, the fact that a quantity of goods and services is offered for sale is evidence of an equal quantity of demand. This claim is often summarized as "Supply creates its own demand", although that phrase does not appear in Say's writings.

Explaining his point at length, he wrote: “It is worthwhile to remark that a product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value. When the producer has put the finishing hand to his product, he is most anxious to sell it immediately, lest its value should diminish in his hands. Nor is he less anxious to dispose of the money he may get for it; for the value of money is also perishable. But the only way of getting rid of money is in the purchase of some product or other. Thus the mere circumstance of creation of one product immediately opens a vent for other products.” Say further argued that because production necessarily creates demand, a "general glut" of unsold goods of all kinds is impossible. If there is an excess supply of one good, there must be a shortage of another: "The superabundance of goods of one description arises from the deficiency of goods of another description." Say rejected the possibility that money obtained from the sale of goods could remain unspent, thereby reducing demand below supply. He viewed money only as a temporary medium of exchange. Money performs but a momentary function in this double exchange; and when the transaction is finally closed, it will always be found, that one kind of commodity has been exchanged for another. Early opinions Early writers on political economy held a variety of opinions on what we now call Say’s law. James Mill and David Ricardo both supported the law in full. Thomas Malthus and John Stuart Mill questioned the doctrine that general gluts cannot occur. James Mill and David Ricardo restated and developed Say's law. Mill wrote, "The production of commodities creates, and is the one and universal cause which creates, a market for the commodities produced." Ricardo wrote, "Demand depends only on supply." Thomas Malthus, on the other hand, rejected Say’s law because he saw evidence of general gluts. We hear of glutted markets, falling prices, and cotton goods selling at Kamschatka lower than the costs of production. It may be said, perhaps, that the cotton trade happens to be glutted; and it is a tenet of the new doctrine on profits and demand, that if one trade be overstocked with capital, it is a certain sign that some other trade is understocked. But where, I would ask, is there any considerable trade that is confessedly under-stocked, and where high profits have been long pleading in vain for additional capital? John Stuart Mill also recognized general gluts. He argued that during a general glut, there is insufficient demand for all non-monetary commodities and excess demand for money. When there is a general anxiety to sell, and a general disinclination to buy, commodities of all kinds remain for a long time unsold, and those which find an immediate market, do so at a very low price... At periods such as we have described... persons in general... liked better to possess money than any other commodity. Money, consequently, was in request, and all other commodities were in comparative disrepute... As there may be a temporary excess of any one article considered separately, so may there of commodities generally, not in consequence of over-production, but of a want of commercial confidence.[14] Mill rescued the claim that there cannot be a simultaneous glut of all commodities by including money as one of the commodities. In order to render the argument for the impossibility of an excess of all commodities applicable... money must itself be considered as a commodity. It must, undoubtedly, be admitted that there cannot be an excess of all other commodities, and an excess of money at the same time.[15] Contemporary economist Brad DeLong considers that Mill’s argument refutes the assertions that a general glut cannot occur, and that a market economy naturally tends towards an equilibrium in which general gluts do not occur.[16][17] What remains of Say's law, after Mill's modification, are a few less controversial assertions: •	In the long run, the ability to produce does not outstrip the desire to consume. •	In a barter economy, a general glut cannot occur. •	In a monetary economy, a general glut occurs not because sellers produce more commodities of every kind than buyers wish to purchase, but because buyers increase their desire to hold money.[18] Say himself never used many of the later, short definitions of Say's law, and thus the law actually developed through the work of many of his contemporaries and successors. The work of James Mill, David Ricardo, John Stuart Mill, and others evolved Say's law into what is sometimes called "law of markets", which was a key element of the framework of macroeconomics from the mid-19th century until the 1930s. Say's law and the Great Depression The Great Depression posed a challenge to Say's law. In the United States, unemployment rose to 25%. The quarter of the labor force that was unemployed constituted a supply of labor for which the demand predicted by Say's law did not exist. John Maynard Keynes argued in 1936 that Say's law is simply not true, and that demand, rather than supply, is the key variable that determines the overall level of economic activity. According to Keynes, demand depends on the propensity of individuals to consume and on the propensity of businesses to invest, both of which vary throughout the business cycle. There is no reason to expect enough aggregate demand to produce full employment.

Say's law today Today, most mainstream economists reject Say's law. Steven Kates, although a proponent of Say's Law, writes: “Before the Keynesian Revolution, denial of the validity of Say's Law placed an economist amongst the crackpots, people with no idea whatsoever about how an economy works. That the vast majority of the economics profession today would have been classified as crackpots in the 1930s and before is just how it is.” However, some proponents of the heterodox Austrian school of economics maintain that the economy tends to full-employment equilibrium, and that recessions and depressions are the result of government intervention in the economy. Some proponents of real business cycle theory maintain that high unemployment is due to a reduced labor supply rather than reduced demand. In other words, people choose to work less when economic conditions are poor, so that involuntary unemployment does not actually exist. Furthermore, some politicians today believe Say's law. For example, French President François Hollande declared, "Supply actually creates demand."

Consequences A number of laissez-faire consequences have been drawn from interpretations of Say's law. However, Say himself advocated public works to remedy unemployment and criticized Ricardo for neglecting the possibility of hoarding if there was a lack of investment opportunities. Recession and Unemployment: Say argued against claims that businesses suffer because people do not have enough money. He argued that the power to purchase can only be increased through more production. James Mill used Say's law against those who sought to give the economy a boost via unproductive consumption. In his view, consumption destroys wealth, in contrast to production, which is the source of economic growth. The demand for a product determines the price of the product. According to Keynes, if Say's law is correct, widespread involuntary unemployment (caused by inadequate demand) cannot occur. Classical economists in the context of Say's law explain unemployment as arising from insufficient demand for specialized labour—that is, the supply of viable labour exceeds demand in some segments of the economy. When more goods are produced by firms than are demanded in certain sectors, the suppliers in those sectors lose revenue as result. This loss of revenue, which would in turn have been used to purchase other goods from other firms, lowers demand for the products of firms in other sectors, causing an overall general reduction in output and thus lowering the demand for labour. This results in what contemporary macroeconomics call structural unemployment, the presumed mismatch between the overall demand for labour in jobs offered and the individual job skills and location of labour. This differs from the Keynesian concept of cyclical unemployment, which is presumed to arise because of inadequate aggregate demand. Such economic losses and unemployment were seen by some economists, such as Marx and Keynes himself, as an intrinsic property of the capitalist system. The division of labor leads to a situation where one always has to anticipate what others will be willing to buy, and this leads to miscalculations. However, this theory alone does not explain the existence of cyclical phenomena in the economy, because such miscalculations would happen with constant frequency, and to such a large scale that thousands of businesses in multiple sectors would simultaneously miscalculate (as during an economic bubble).[according to whom?]

Assumptions and criticisms Say's law did not posit that (as per the Keynesian formulation) "supply creates its own demand". Nor was it based on the idea that everything that is saved will be exchanged. Rather, Say sought to refute the idea that production and employment were limited by low consumption. Thus Say's law, in its original concept, was not intrinsically linked nor logically reliant on the neutrality of money (as has been alleged by those who wish to disagree with it), because the key proposition of the law is that no matter how much people save, production is still a possibility, as it is the prerequisite for the attainment of any additional consumption goods. Say's law states that in a market economy, goods and services are produced for exchange with other goods and services—"employment multipliers" therefore arise from production and not exchange alone—and that in the process a sufficient level of real income is created to purchase the economy's entire output, due to the truism that the means of consumption are limited ex vi termini by the level of production. That is, with regard to the exchange of products within a division of labour, the total supply of goods and services in a market economy will equal the total demand derived from consumption during any given time period. In modern terms, "general gluts cannot exist", although there may be local imbalances, with gluts in some markets balanced out by shortages in others. Nevertheless, for some neoclassical economists, Say's law implies that economy is always at its full employment level. This is not necessarily what Say proposed. In the Keynesian interpretation, the assumptions of Say's law are: •	a barter model of money ("products are paid for with products"); •	flexible prices—that is, all prices can rapidly adjust upwards or downwards; and •	no government intervention. Under these assumptions, Say's law implies that there cannot be a general glut, so that a persistent state cannot exist in which demand is generally less than productive capacity and high unemployment results. Keynesians therefore argued that the Great Depression demonstrated that Say's law is incorrect. Keynes, in his General Theory, argued that a country could go into a recession because of "lack of aggregate demand". Because historically there have been many persistent economic crises, one may reject one or more of the assumptions of Say's law, its reasoning, or its conclusions. Taking the assumptions in turn: •	Circuitists and some post-Keynesians dispute the barter model of money, arguing that money is fundamentally different from commodities and that credit bubbles can and do cause depressions. Notably, the debt owed does not change because the economy has changed. •	Keynes argued that prices are not flexible; for example, workers may not take pay cuts if the result is starvation.[citation needed] •	Laissez-faire economists[who?] argue that government intervention is the cause of economic crises, and that left to its devices, the market will adjust efficiently. As for the implication that dislocations cannot cause persistent unemployment, some theories of economic cycles accept Say's law and seek to explain high unemployment in other ways, considering depressed demand for labour as a form of local dislocation. For example, advocates of Real Business Cycle Theory argue that real shocks cause recessions and that the market responds efficiently to these real economic shocks. Paul Krugman dismisses Say's law as, "at best, a useless tautology when individuals have the option of accumulating money rather than purchasing real goods and services."

Role of money It is not easy to say what exactly Say's law says about the role of money apart from the claim that recession is not caused by lack of money. The phrase "products are paid for with products" is taken to mean that Say has a barter model of money; contrast with circuitist and post-Keynesian monetary theory. One can read Say as stating simply that money is completely neutral, although he did not state this explicitly, and in fact did not concern himself with this subject. Say's central notion concerning money was that if one has money, it is irrational to hoard it. The assumption that hoarding is irrational was attacked by under consumptionist economists, such as John M. Robertson, in his 1892 book, The Fallacy of Saving,[32][33] where he called Say's law: a tenacious fallacy, consequent on the inveterate evasion of the plain fact that men want for their goods, not merely some other goods to consume, but further, some credit or abstract claim to future wealth, goods, or services. This all want as a surplus or bonus, and this surplus cannot be represented for all in present goods. —John M. Robertson, The Fallacy of Saving, Here Robertson identifies his critique as based on Say's theory of money: people wish to accumulate a "claim to future wealth", not simply present goods, and thus the hoarding of wealth may be rational. For Say, as for other classical economists, it is quite possible for there to be a glut (excess supply, market surplus) for one product alongside a shortage (excess demand) of others. But there is no "general glut" in Say's view, since the gluts and shortages cancel out for the economy as a whole. But what if the excess demand is for money, because people are hoarding it? This creates an excess supply for all products, a general glut. Say's answer is simple: there is no reason to engage in hoarding money. According to Say, the only reason to have money is to buy products. It would not be a mistake, in his view, to treat the economy as if it were a barter economy. To quote Say: Nor is [an individual] less anxious to dispose of the money he may get ... But the only way of getting rid of money is in the purchase of some product or other.[34] In Keynesian terms, followers of Say's law would argue that on the aggregate level, there is only a transactions demand for money. That is, there is no precautionary, finance, or speculative demand for money. Money is held for spending, and increases in money supplies lead to increased spending. Some classical economists did see that a loss of confidence in business or a collapse of credit will increase the demand for money, which will decrease the demand for goods. This view was expressed both by Robert Torrens and John Stuart Mill. This would lead demand and supply to move out of phase and lead to an economic downturn in the same way that miscalculation in productions would, as described by William H. Beveridge in 1909. However, in classical economics, there was no reason for such a collapse to persist. In this view, persistent depressions, such as that of the 1930s, are impossible in a free market organized according to laissez-faire principles. The flexibility of markets under laissez faire allows prices, wages, and interest rates to adjust so as to abolish all excess supplies and demands; however, since all economies are a mixture of regulation and free-market elements, laissez-faire principles (which require a free market environment) cannot adjust effectively to excess supply and demand. Say's law as a theoretical point of departure The whole of neoclassical equilibrium analysis implies that Say's law in the first place functioned to bring a market into this state: that is, Say's law is the mechanism through which markets equilibrate uniquely. Equilibrium analysis and its derivatives of optimization and efficiency in exchange live or die with Say's law. This is one of the major, fundamental points of contention between the neoclassical tradition, Keynes, and Marxians. Ultimately, from Say's law they deduced vastly different conclusions regarding the functioning of capitalist production. The former, not to be confused with "new Keynesian" and the many offsprings and syntheses of the "General Theory", take the fact that a commodity–commodity economy is substantially altered once it becomes a commodity–money–commodity economy, or once money becomes not only a facilitator of exchange (its only function in marginalist theory) but also a store of value and a means of payment. What this means is that money can be (and must be) hoarded: it may not re-enter the circulatory process for some time, and thus a general glut is not only possible but, to the extent that money is not rapidly turned over, probable. A response to this in defense of Say's law (echoing the debates between Ricardo and Malthus, in which the former denied the possibility of a general glut on its grounds) is that consumption that is abstained from through hoarding is simply transferred to a different consumer—overwhelmingly to factor (investment) markets, which, through financial institutions, function through the rate of interest. Keynes' innovation in this regard was twofold: First, he was to turn the mechanism that regulates savings and investment, the rate of interest, into a shell of its former self (relegating it to the price of money) by showing that supply and investment were not independent of one another and thus could not be related uniquely in terms of the balancing of disutility and utility. Second, after Say's law was dealt with and shown to be theoretically inconsistent, there was a gap to be filled. If Say's law was the logic by which we thought financial markets came to a unique position in the long run, and if Say's law were to be discarded, what were the real "rules of the game" of the financial markets? How did they function and remain stable? To this Keynes responded with his famous notion of "Animal Spirits": markets were ruled by speculative behavior, influenced not only by one's own personal equation but also by one's perceptions of the speculative behavior of others. In turn, others' behavior was motivated by their perceptions of others' behavior, and so on. Without Say's law keeping them in balance, financial markets were thus inherently unstable. Through this identification, Keynes deduced the consequences of the macroeconomy of long-run equilibrium being attained not at only one unique position that represented a "Pareto Optima" (a special case), but through a possible range of many equilibria that could significantly under-employ human and natural resources (the general case). For the Marxian critique, which is more fundamental, one must start at Marx's initial distinction between use value and exchange value, use value being the use somebody has for a commodity, and exchange value being what an item is traded for on a market. In Marx's theory, there is a gap between the creation of surplus value in production and the realization of that surplus value via a sale. To realize a sale, a commodity must have a use value for someone, in order for them to purchase the commodity and complete the cycle M–C–M'. Capitalism, which is purely interested in value (money as wealth), must create use value. The capitalist has no control over whether or not the value contained in the product is realized through the market mechanism. This gap between production and realization creates the possibility for capitalist crisis. As the realization of capital is only possible through a market, Marx criticized other economists, such as David Ricardo, who argued that capital is realized via production. Thus, in Marx's theory, there can be general overproductive crises within capitalism.[35] Given these concepts and their implications, Say's law does not hold in the Marxian framework. Moreover, the theoretical core of the Marxian framework contrasts with that of the neoclassical and Austrian traditions. Conceptually, the distinction between Keynes and Marx is that for Keynes the theory is but a special case of his general theory, whereas for Marx it never existed at all. Modern interpretations A modern way of expressing Say's law is that there can never be a general glut. Instead of there being an excess supply (glut or surplus) of goods in general, there may be an excess supply of one or more goods, but only when balanced by an excess demand (shortage) of yet other goods. Thus, there may be a glut of labor ("cyclical" unemployment), but this is balanced by an excess demand for produced goods. Modern advocates of Say's law see market forces as working quickly, via price adjustments, to abolish both gluts and shortages. The exception is when governments or other non-market forces prevent price adjustments. According to Keynes, the implication of Say's law is that a free-market economy is always at what Keynesian economists call full employment (see also Walras' law). Thus, Say's law is part of the general world view of laissez-faire economics—that is, that free markets can solve the economy's problems automatically. (These problems are recessions, stagnation, depression, and involuntary unemployment.) Some proponents of Say's law argue that such intervention is always counterproductive. Consider Keynesian-type policies aimed at stimulating the economy. Increased government purchases of goods (or lowered taxes) merely "crowd out" the production and purchase of goods by the private sector. Contradicting this view, Arthur Cecil Pigou, a self-proclaimed follower of Say's law, wrote a letter in 1932 signed by five other economists (among them Keynes) calling for more public spending to alleviate high levels of unemployment. Keynes versus Say For more details on this topic, see Supply creates its own demand. Keynes summarized Say's law as "supply creates its own demand", or the assumption "that the whole of the costs of production must necessarily be spent in the aggregate, directly or indirectly, on purchasing the product" (from chapter 2 of his General Theory). Keynesian economists, such as Paul Krugman, stress the role of money in negating Say's law: Money that is hoarded (held as cash or analogous financial instruments) is not spent on products. To increase monetary holdings, someone may sell products or labor without immediately spending the proceeds. This can be a general phenomenon: from time to time, in response to changing economic circumstances, households and businesses in aggregate seek to increase net savings and thus decrease net debt. To increase net savings requires earning more than is spent—contrary to Say's law, which postulates that supply (sales, earning income) equals demand (purchases, requiring spending). Keynesian economists argue that the failure of Say's law, through an increased demand for monetary holdings, can result in a general glut due to falling demand for goods and services. This provides an explanation for recessionary spirals and economic depressions. Without sufficient demand for the products of labor, the availability of jobs will be low; without enough jobs, working people will receive inadequate income, implying insufficient demand for products. Thus, an aggregate demand failure involves a vicious circle: if a worker supplies more labor time (in order to buy more goods), he or she may be frustrated because no one is hiring—that is, because there is no increase in the demand for the worker's products until after he or she gets a job and earns an income. (Of course, most employees get paid after working, after some of the product is sold.) Further, unlike the Say's law story above, there are interactions between different markets (and their gluts and shortages) that go beyond the simple price mechanism, to limit the quantity of jobs supplied and the quantity of products demanded. Some classical economists suggested that hoarding (increases in money-equivalent holdings) would always be balanced by dis-hoarding. This requires equality of saving (abstention from purchase of goods) and investment (the purchase of capital goods). However, Keynes and others argued that hoarding decisions are made by different people and for different reasons than are decisions to dis-hoard, so that hoarding and dis-hoarding are unlikely to be equal at all times, as indeed they are not. Decreasing demand (consumption) does not necessarily stimulate capital spending (investment). Some have argued that financial markets, and especially interest rates, could adjust to keep hoarding and dis-hoarding equal, so that Say's law could be maintained, or that prices could simply fall, to prevent a decrease in production. (See the discussion of "excess saving" under "Keynesian economics".) But Keynes argued that in order to play this role, interest rates would have to fall rapidly and that there were limits on how quickly and how low they could fall (as in the liquidity trap, where interest rates approach zero and cannot fall further). To Keynes, in the short run, interest rates were determined more by the supply and demand for money than by saving and investment. Before interest rates could adjust sufficiently, excessive hoarding would cause the vicious circle of falling aggregate production (recession). The recession itself would lower incomes so that hoarding (and saving) and dis-hoarding (and real investment) could reach a state of balance below full employment. Worse, a recession would hurt private real investment—by hurting profitability and business confidence—through what is called the accelerator effect. This means that the balance between hoarding and dis-hoarding would be pushed even further below the full-employment level of production. Keynesians argue that this kind of vicious circle can be broken by stimulating the aggregate demand for products using various macroeconomic policies mentioned in the introduction above, making Say's law true in practice when it is false in theory. Increases in the demand for products lead to increased supply (production) and an increased availability of jobs, and thus to further increases in demand and in production. This cumulative causation is called the multiplier process.

Quantity theory of money In monetary economics, the quantity theory of money states that money supply has a direct, proportional relationship with the price level. For example, if the currency in circulation increased, there would be a proportional increase in the price of goods. The theory was challenged by Keynesian economics, but updated and reinvigorated by the monetarist school of economics. While mainstream economists agree that the quantity theory holds true in the long run, there is still disagreement about its applicability in the short run. Critics of the theory argue that money velocity is not stable and, in the short-run, prices are sticky, so the direct relationship between money supply and price level does not hold. Alternative theories include the real bills doctrine and the more recent fiscal theory of the price level. Origins and development of the quantity theory The quantity theory descends from Copernicus, followers of the School of Salamanca, Jean Bodin, Henry Thornton, and various others who noted the increase in prices following the import of gold and silver, used in the coinage of money, from the New World. The “equation of exchange” relating the supply of money to the value of money transactions was stated by John Stuart Mill who expanded on the ideas of David Hume. The quantity theory was developed by Simon Newcomb, Alfred de Foville, Irving Fisher, and Ludwig von Mises in the late 19th and early 20th century. Henry Thornton introduced the idea of a central bank after the financial panic of 1793, although, the concept of a modern central bank wasn't given much importance until Keynes published "A Tract on Monetary Reform" in 1923. In 1802, Thornton published "An Enquiry into the Nature and Effects of the Paper Credit of Great Britain" in which he gave an account of his theory regarding the central bank's ability to control price level. According to his theory, the central bank could control the currency in circulation through book keeping. This control could allow the central bank to gain a command of the money supply of the country. This ultimately would lead to the central bank's ability to control the price level. His introduction of the central bank's ability to influence the price level was a major contribution to the development of the quantity theory of money. Karl Marx modified it by arguing that the Labor Theory of Value requires that prices, under equilibrium conditions, are determined by socially necessary labor time needed to produce the commodity and that quantity of money was a function of the quantity of commodities, the prices of commodities, and the velocity. Marx did not reject the basic concept of the Quantity Theory of Money, but rejected the notion that each of the four elements were equal, and instead argued that the quantity of commodities and the price of commodities are the determinative elements and that the volume of money follows from them. He argued, "The law, that the quantity of the circulating medium is determined by the sum of the prices of the commodities circulating, and the average velocity of currency may also be stated as follows: given the sum of the values of commodities, and the average rapidity of their metamorphoses, the quantity of precious metal current as money depends on the value of that precious metal. The erroneous opinion that it is, on the contrary, prices that are determined by the quantity of the circulating medium, and that the latter depends on the quantity of the precious metals in a country; this opinion was based by those who first held it, on the absurd hypothesis that commodities are without a price, and money without a value, when they first enter into circulation, and that, once in the circulation, an aliquot part of the medley of commodities is exchanged for an aliquot part of the heap of precious metals." John Maynard Keynes, like Marx, accepted the theory in general and wrote, "This Theory is fundamental. Its correspondence with fact is not open to question." Also like Marx he believed that the theory was misrepresented. Where Marx argues that the amount of money in circulation is determined by the quantity of goods times the prices of goods Keynes argued the amount of money was determined by the purchasing power or aggregate demand. He wrote, "Thus the number of notes which the public ordinarily have on hand is determined by the purchasing power which it suits them to hold or to carry about, and by nothing else." In the Tract on Monetary Reform (1924), Keynes developed his own quantity equation: n = p(k + rk'),where n is the number of "currency notes or other forms of cash in circulation with the public", p is "the index number of the cost of living", and r is "the proportion of the bank's potential liabilities (k') held in the form of cash." Keynes also assumes "...the public,(k') including the business world, finds it convenient to keep the equivalent of k consumption in cash and of a further available k' at their banks against cheques..." So long as k, k', and r do not change, changes in n cause proportional changes in p. Keynes however notes, "The error often made by careless adherents of the Quantity Theory, which may partly explain why it is not universally accepted is as follows. The Theory has often been expounded on the further assumption that a mere change in the quantity of the currency cannot affect k, r, and k',--that is to say, in mathematical parlance, that n is an independent variable in relation to these quantities. It would follow from this that an arbitrary doubling of n, since this in itself is assumed not to affect k, r, and k', must have the effect of raising p to double what it would have been otherwise. The Quantity Theory is often stated in this, or a similar, form. Now "in the long run" this is probably true. If, after the American Civil War, that American dollar had been stabilized and defined by law at 10 per cent below its present value, it would be safe to assume that n and p would now be just 10 per cent greater than they actually are and that the present values of k, r, and k' would be entirely unaffected. But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean will be flat again. In actual experience, a change in n is liable to have a reaction both on k and k' and on r. It will be enough to give a few typical instances. Before the war (and indeed since) there was a considerable element of what was conventional and arbitrary in the reserve policy of the banks, but especially in the policy of the State Banks towards their gold reserves. These reserves were kept for show rather than for use, and their amount was not the result of close reasoning. There was a decided tendency on the part of these banks between 1900 and 1914 to bottle up gold when it flowed towards them and to part with it reluctantly when the tide was flowing the other way. Consequently, when gold became relatively abundant they tended to hoard what came their way and to raise the proportion of the reserves, with the result that the increased output of South African gold was absorbed with less effect on the price level than would have been the case if an increase of n had been totally without reaction on the value of r. ...Thus in these and other ways the terms of our equation tend in their movements to favor the stability of p, and there is a certain friction which prevents a moderate change in v from exercising its full proportionate effect on p. On the other hand, a large change in n, which rubs away the initial frictions, and especially a change in n due to causes which set up a general expectation of a further change in the same direction, may produce a more than proportionate effect on p". Keynes thus accepts the Quantity Theory as accurate over the long-term but not over the short term. Keynes remarks that contrary to contemporaneous thinking, velocity and output were not stable but highly variable and as such, the quantity of money was of little importance in driving prices.[16] The theory was influentially restated by Milton Friedman in response to the work of John Maynard Keynes and Keynesianism.[17] Friedman understood that Keynes was like Friedman, a "quantity theorist" and that Keynes Revolution "was from, as it were, within the governing body", i.e. consistent with previous Quantity Theory.[16] Friedman notes the similarities between his views and those of Keynes when he wrote... "A counter-revolution, whether in politics or in science, never restores the initial situation. It always produces a situation that has some similarity to the initial one but is also strongly influenced by the intervening revolution. That is certainly true of monetarism which has benefited much from Keynes’s work. Indeed I may say, as have so many others since there is no way of contradicting it, that if Keynes were alive today he would no doubt be at the forefront of the counter-revolution." Friedman notes that Keynes shifted the focus away from the quantity of money (Fisher's M and Keynes' n) and put the focus on price and output. Friedman writes... "What matters, said Keynes, is not the quantity of money. What matters is the part of total spending which is independent of current income, what has come to be called autonomous spending and to be identified in practice largely with investment by business and expenditures by government." The Monetarist counter-position was that contrary to Keynes, velocity was not a passive function of the quantity of money but it can be an independent variable. Friedman wrote: "Perhaps the simplest way for me to suggest why this was relevant is to recall that an essential element of the Keynesian doctrine was the passivity of velocity. If money rose, velocity would decline. Empirically, however, it turns out that the movements of velocity tend to reinforce those of money instead of to offset them. When the quantity of money declined by a third from 1929 to 1933 in the United States, velocity declined also. When the quantity of money rises rapidly in almost any country, velocity also rises rapidly. Far from velocity offsetting the movements of the quantity of money, it reinforces them." Thus while Marx, Keynes, and Friedman all accepted the Quantity Theory, they each placed different emphasis as to which variable was the driver in changing prices. Marx emphasized production, Keynes income and demand, and Friedman the quantity of money. Academic discussion remains over the degree to which different figures developed the theory.[18] For instance, Bieda argues that Copernicus's observation Money can lose its value through excessive abundance, if so much silver is coined as to heighten people's demand for silver bullion. For in this way, the coinage's estimation vanishes when it cannot buy as much silver as the money itself contains […]. The solution is to mint no more coinage until it recovers its par value. amounts to a statement of the theory, while other economic historians date the discovery later, to figures such as Jean Bodin, David Hume, and John Stuart Mill. Historically, the main rival of the quantity theory was the real bills doctrine, which says that the issue of money does not raise prices, as long as the new money is issued in exchange for assets of sufficient value. Equation of exchange In its modern form, the quantity theory builds upon the following definitional relationship. where is the total amount of money in circulation on average in an economy during the period, say a year. is the transactions velocity of money, that is the average frequency across all transactions with which a unit of money is spent. This reflects availability of financial institutions, economic variables, and choices made as to how fast people turn over their money. and are the price and quantity of the i-th transaction. is a column vector of the, and the superscript T is the transpose operator. is a column vector of the. Mainstream economics accepts a simplification, the equation of exchange: where is the price level associated with transactions for the economy during the period is an index of the real value of aggregate transactions. The previous equation presents the difficulty that the associated data are not available for all transactions. With the development of national income and product accounts, emphasis shifted to national-income or final-product transactions, rather than gross transactions. Economists may therefore work with the form where is the velocity of money in final expenditures. is an index of the real value of final expenditures. As an example, might represent currency plus deposits in checking and savings accounts held by the public,  real output (which equals real expenditure in macroeconomic equilibrium) with  the corresponding price level, and  the nominal (money) value of output. In one empirical formulation, velocity was taken to be “the ratio of net national product in current prices to the money stock”.[22] Thus far, the theory is not particularly controversial, as the equation of exchange is an identity. A theory requires that assumptions be made about the causal relationships among the four variables in this one equation. There are debates about the extent to which each of these variables is dependent upon the others. Without further restrictions, the equation does not require that a change in the money supply would change the value of any or all of,  , or. For example, a 10% increase in could be accompanied by a change of 1/(1 + 10%) in , leaving  unchanged. The quantity theory postulates that the primary causal effect is an effect of M on P. Cambridge approach Economists Alfred Marshall, A.C. Pigou, and John Maynard Keynes (before he developed his own, eponymous school of thought) associated with Cambridge University, took a slightly different approach to the quantity theory, focusing on money demand instead of money supply. They argued that a certain portion of the money supply will not be used for transactions; instead, it will be held for the convenience and security of having cash on hand. This portion of cash is commonly represented as k, a portion of nominal income. The Cambridge economists also thought wealth would play a role, but wealth is often omitted for simplicity. The Cambridge equation is thus: Assuming that the economy is at equilibrium, is exogenous, and k is fixed in the short run, the Cambridge equation is equivalent to the equation of exchange with velocity equal to the inverse of k: The Cambridge version of the quantity theory led to both Keynes's attack on the quantity theory and the Monetarist revival of the theory.[23] Quantity theory and evidence As restated by Milton Friedman, the quantity theory emphasizes the following relationship of the nominal value of expenditures and the price level  to the quantity of money  : The plus signs indicate that a change in the money supply is hypothesized to change nominal expenditures and the price level in the same direction (for other variables held constant). Friedman described the empirical regularity of substantial changes in the quantity of money and in the level of prices as perhaps the most-evidenced economic phenomenon on record.[24] Empirical studies have found relations consistent with the models above and with causation running from money to prices. The short-run relation of a change in the money supply in the past has been relatively more associated with a change in real output than the price level  in (1) but with much variation in the precision, timing, and size of the relation. For the long-run, there has been stronger support for (1) and (2) and no systematic association of and. Principles The theory above is based on the following hypotheses: 1.	The source of inflation is fundamentally derived from the growth rate of the money supply. 2.	The supply of money is exogenous. 3.	The demand for money, as reflected in its velocity, is a stable function of nominal income, interest rates, and so forth. 4.	The mechanism for injecting money into the economy is not that important in the long run. 5.	The real interest rate is determined by non-monetary factors: (productivity of capital, time preference). Decline of money-supply targeting An application of the quantity-theory approach aimed at removing monetary policy as a source of macroeconomic instability was to target a constant, low growth rate of the money supply.[26] Still, practical identification of the relevant money supply, including measurement, was always somewhat controversial and difficult. As financial intermediation grew in complexity and sophistication in the 1980s and 1990s, it became more so. To mitigate these problem, some central banks, including the U.S. Federal Reserve, which had targeted the money supply, reverted to targeting interest rates. Starting 1990 with New Zealand, more and more central banks started to communicate inflation targets as the primary guidance for the public. Reasons were that interest targeting turned out to be a less effective tool in low-interest phases and it did not cope with the public uncertainty about future inflation rates to expect. The communication of inflation targets helps to anchor the public inflation expectations, it makes central banks more accountable for their actions, and it reduces economic uncertainty among the participants in the economy. But monetary aggregates remain a leading economic indicator.[28] with "some evidence that the linkages between money and economic activity are robust even at relatively short-run frequencies." Criticisms Knut Wicksell criticized the quantity theory of money. John Maynard Keynes criticized the quantity theory of money in The General Theory of Employment, Interest and Money. Keynes had originally been a proponent of the theory, but he presented an alternative in the General Theory. Keynes argued that price level was not strictly determined by money supply. Changes in the money supply could have effects on real variables like output. Ludwig von Mises agreed that there was a core of truth in the Quantity Theory, but criticized its focus on the supply of money without adequately explaining the demand for money. He said the theory "fails to explain the mechanism of variations in the value of money".

Neo-Classical Monetary Theory Cambridge approach/ Cash-Balance Approach The Cambridge equation formally represents the Cambridge cash-balance theory, an alternative approach to the classical quantity theory of money. Both quantity theories, Cambridge and classical, attempt to express a relationship among the amount of goods produced, the price level, amounts of money, and how money moves. The Cambridge equation focuses on money demand instead of money supply. The theories also differ in explaining the movement of money: In the classical version, associated with Irving Fisher, money moves at a fixed rate and serves only as a medium of exchange while in the Cambridge approach money acts as a store of value and its movement depends on the desirability of holding cash.

Economists associated with Cambridge University, including Alfred Marshall, A.C. Pigou, and John Maynard Keynes (before he developed his own, eponymous school of thought) contributed to a quantity theory of money that paid more attention to money demand than the supply-oriented classical version. The Cambridge economists argued that a certain portion of the money supply will not be used for transactions; instead, it will be held for the convenience and security of having cash on hand. This portion of cash is commonly represented as k, a portion of nominal income (the product of the price level and real income), ). The Cambridge economists also thought wealth would play a role, but wealth is often omitted from the equation for simplicity. The Cambridge equation is thus: Assuming that the economy is at equilibrium, is exogenous, and k is fixed in the short run, the Cambridge equation is equivalent to the equation of exchange with velocity equal to the inverse of k: History and significance The Cambridge equation first appeared in print in 1917 in Pigou's "Value of Money". Keynes contributed to the theory with his 1923 Tract on Monetary Reform. The Cambridge version of the quantity theory led to both Keynes's attack on the quantity theory and the Monetarist revival of the theory. Marshall recognized that k would be determined in part by an individual's desire to hold liquid cash. In his General Theory of Employment, Interest and Money, Keynes expanded on this concept to develop the idea of liquidity preference, a central Keynesian concept.

Monetarism In monetary economics, monetarism is a school of thought that emphasizes the role of governments in controlling the amount of money in circulation. Monetarists believe that variation in the money supply has major influences on national output in the short run and the price level over longer periods, and that objectives of monetary policy are best met by targeting the growth rate of the money supply rather than by engaging in discretionary monetary policy. Monetarism today is mainly associated with the work of Milton Friedman, who was among the generation of economists to accept Keynesian economics and then criticise Keynes' theory of gluts using fiscal policy (government spending). Friedman and Anna Schwartz wrote an influential book, A Monetary History of the United States, 1867–1960, and argued "inflation is always and everywhere a monetary phenomenon." Though he opposed the existence of the Federal Reserve, Friedman advocated, given its existence, a central bank policy aimed at keeping the supply and demand for money at equilibrium, as measured by growth in productivity and demand. Description Monetarism is an economic theory that focuses on the macroeconomic effects of the supply of money and central banking. Formulated by Milton Friedman, it argues that excessive expansion of the money supply is inherently inflationary, and that monetary authorities should focus solely on maintaining price stability. This theory draws its roots from two historically antagonistic schools of thought: the hard money policies that dominated monetary thinking in the late 19th century, and the monetary theories of John Maynard Keynes, who, working in the inter-war period during the failure of the restored gold standard, proposed a demand-driven model for money. While Keynes had focused on the value stability of currency, with the resulting panics based on an insufficient money supply leading to alternate currency and collapse, then Friedman focused on price stability, which is the equilibrium between supply and demand for money. The result was summarized in a historical analysis of monetary policy, Monetary History of the United States 1867–1960, which Friedman coauthored with Anna Schwartz. The book attributed inflation to excess money supply generated by a central bank. It attributed deflationary spirals to the reverse effect of a failure of a central bank to support the money supply during a liquidity crunch. Friedman originally proposed a fixed monetary rule, called Friedman's k-percent rule, where the money supply would be automatically increased by a fixed percentage per year. Under this rule, there would be no leeway for the central reserve bank as money supply increases could be determined "by a computer", and business could anticipate all money supply changes. With other monetarists he believed that the active manipulation of the money supply or its growth rate is more likely to destabilise than stabilise the economy. Opposition to the gold standard Most monetarists oppose the gold standard. Friedman, for example, viewed a pure gold standard as impractical. For example, whereas one of the benefits of the gold standard is that the intrinsic limitations to the growth of the money supply by the use of gold or silver would prevent inflation, if the growth of population or increase in trade outpaces the money supply, there would be no way to counteract deflation and reduced liquidity (and any attendant recession) except for the mining of more gold or silver under a gold or silver standard. Rise Clark Warburton is credited with making the first solid empirical case for the monetarist interpretation of business fluctuations in a series of papers from 1945. Within mainstream economics, the rise of monetarism accelerated from Milton Friedman's 1956 restatement of the quantity theory of money. Friedman argued that the demand for money could be described as depending on a small number of economic variables. Thus, where the money supply expanded, people would not simply wish to hold the extra money in idle money balances; i.e., if they were in equilibrium before the increase, they were already holding money balances to suit their requirements, and thus after the increase they would have money balances surplus to their requirements. These excess money balances would therefore be spent and hence aggregate demand would rise. Similarly, if the money supply were reduced people would want to replenish their holdings of money by reducing their spending. In this, Friedman challenged a simplification attributed to Keynes suggesting that "money does not matter." Thus the word 'monetarist' was coined. The rise of the popularity of monetarism also picked up in political circles when Keynesian economics seemed unable to explain or cure the seemingly contradictory problems of rising unemployment and inflation in response to the collapse of the Bretton Woods system in 1972 and the oil shocks of 1973. On the one hand, higher unemployment seemed to call for Keynesian reflation, but on the other hand rising inflation seemed to call for Keynesian disinflation. In 1979, President Jimmy Carter appointed a Federal Reserve chief Paul Volcker, who made inflation fighting his primary objective, and restricted the money supply (in accordance with the Friedman rule) to tame inflation in the economy. The result was the creation of the desired price stability. Monetarists not only sought to explain present problems; they also interpreted historical ones. Milton Friedman and Anna Schwartz in their book A Monetary History of the United States, 1867–1960 argued that the Great Depression of 1930 was caused by a massive contraction of the money supply and not by the lack of investment Keynes had argued. They also maintained that post-war inflation was caused by an over-expansion of the money supply. They made famous the assertion of monetarism that 'inflation is always and everywhere a monetary phenomenon'. Many Keynesian economists initially believed that the Keynesian vs. monetarist debate was solely about whether fiscal or monetary policy was the more effective tool of demand management. By the mid-1970s, however, the debate had moved on to other issues as monetarists began presenting a fundamental challenge to Keynesianism. Many monetarists sought to resurrect the pre-Keynesian view that market economies are inherently stable in the absence of major unexpected fluctuations in the money supply. Because of this belief in the stability of free-market economies they asserted that active demand management (e.g. by the means of increasing government spending) is unnecessary and indeed likely to be harmful. The basis of this argument is an equilibrium between "stimulus" fiscal spending and future interest rates. In effect, Friedman's model argues that current fiscal spending creates as much of a drag on the economy by increased interest rates as it creates present consumption: that it has no real effect on total demand, merely that of shifting demand from the investment sector (I) to the consumer sector (C). When Margaret Thatcher, leader of the Conservative Party in the United Kingdom, won the 1979 general election defeating the incumbent Labour Party led by James Callaghan, Britain had endured several years of severe inflation, which was rarely below 10% and by the time of the election in May 1979 stood at 10.3%.[7] Thatcher implemented monetarism as the weapon in her battle against inflation, and succeeded at reducing it to 4.6% by 1983. James Callaghan himself had adopted policies echoing monetarism while serving as prime minister from 1976 to 1979, adopting deflationary policies and reducing public spending in response to high inflation and national debt. He initially had some success, as inflation was below 10% by the summer of 1978, although unemployment now stood at 1,500,000. However, by the time of his election defeat barely a year later, inflation had soared to 27%. Criticism According to Alan Blinder and Robert Solow,[9] fiscal policy becomes impotent only when an interest-elasticity of the demand for money is zero. Empirically, such a perfect inelasticity does not occur. However, there are limited policy options when the interest rate is at or near the zero lower bound. Although Milton Friedman[9] believed that wealth effects make deficit spending contractionary, Blinder and Solow believed that in reality fiscal stimulus is effective. To see this, they used a government budget constraint equation which includes interest on government bonds: where B is the number of bonds whose face value per unit bond is 1 dollar. T is the tax function. In the long-run stationary state, , which gives Immediately, it turns out that under money financing the fiscal multiplier becomes because in this case. Both monetarists and Keynesians agree with the idea[9] that money-financed deficit spending has an expansionary impact on the economy. If deficits are financed by bonds, the long-run fiscal multiplier becomes larger than that by money-creation: Thus their research shows that, in the long run, bond-financed government spending increases the income level more than money-financed deficit spending does. Practice A realistic theory should be able to explain the deflationary waves of the late 19th century, the Great Depression, and the stagflation period beginning with the uncoupling of exchange rates in 1972. Monetarists argue that there was no inflationary investment boom in the 1920s. Instead, monetarist thinking centers on the contraction of the M1 during the 1931–1933 period, and argues from there that the Federal Reserve could have avoided the Great Depression by moves to provide sufficient liquidity. In essence, they argue that there was an insufficient supply of money. From their conclusion that incorrect central bank policy is at the root of large swings in inflation and price instability, monetarists argued that the primary motivation for excessive easing of central bank policy is to finance fiscal deficits by the central government. Hence, restraint of government spending is the most important single target to restrain excessive monetary growth. With the failure of demand-driven fiscal policies to restrain inflation and produce growth in the 1970s, the way was paved for a new policy of fighting inflation through the central bank, which would be the bank's cardinal responsibility. In typical economic theory, this would be accompanied by austerity shock treatment, as is generally recommended by the International Monetary Fund: such a course was taken in the United Kingdom, where government spending was slashed in the late 1970s and early 1980s under the political ascendance of Prime Minister Margaret Thatcher. In the United States, the opposite approach was taken and real government spending increased much faster during President Ronald Reagan's first four years (4.22%/year) than it did under Carter (2.55%/year).[10] In the ensuing short term, unemployment in both countries remained stubbornly high while central banks raised interest rates to restrain credit. These policies dramatically reduced inflation rates in both countries (the United States' inflation rate fell from almost 14% in 1980 to around 3% in 1983[citation needed]), allowing liberalisation of credit and the reduction of interest rates, which led ultimately to the inflationary economic booms of the 1980s. Arguments have been raised, however, that the fall of the inflation rate may be less from control of the money supply and more to do with the unemployment level's effect on demand; some also claim the use of credit to fuel economic expansion is itself an anti-monetarist tool, as it can be argued that an increase in money supply alone constitutes inflation.[citation needed] Monetarism re-asserted itself in central bank policy in western governments at the end of the 1980s and beginning of the 1990s, with a contraction both in spending and in the money supply, ending the booms experienced in the US and UK. 1990s In the late 1980s, Paul Volcker was succeeded by Alan Greenspan. His handling of monetary policy in the run-up to the 1991 recession was criticised from the right as being excessively tight, and costing George H. W. Bush re-election. The incoming Democratic president Bill Clinton reappointed Alan Greenspan, and kept him as a core member of his economic team. Greenspan, while still fundamentally monetarist in orientation, argued that doctrinaire application of theory was insufficiently flexible for central banks to meet emerging situations. The crucial test of this flexible response by the Federal Reserve was the Asian financial crisis of 1997–1998, which the Federal Reserve met by flooding the world with dollars, and organising a bailout of Long-Term Capital Management. Some have argued that 1997–1998 represented a monetary policy bind, just as the early 1970s had represented a fiscal policy bind, and that while asset inflation had crept into the United States (which demanded that the Fed tighten the money supply), the Federal Reserve needed to ease liquidity in response to the capital flight from Asia. Greenspan himself noted this when he stated that the American stock market showed signs of irrationally high valuations.[11] In 2000, Alan Greenspan raised interest rates several times. These actions were believed by many to have caused the bursting of the dot-com bubble. In late 2001, as a decisive reaction to the September 11 attacks and the various corporate scandals which undermined the economy, the Greenspan-led Federal Reserve initiated a series of interest rate cuts that brought the Federal Funds rate down to 1% in 2004. His critics, notably Steve Forbes, attributed the rapid rise in commodity prices and gold to Greenspan's loose monetary policy[citation needed], and by late 2004 the price of gold was higher than its 12-year moving average; these same forces were also blamed for excessive asset inflation and the weakening of the dollar. These policies of Alan Greenspan are blamed by the followers of the Austrian School for creating excessive liquidity, causing lending standards to deteriorate, and resulting in the housing bubble of 2004–2006. Currently, the American Federal Reserve follows a modified form of monetarism, where broader ranges of intervention are possible in light of temporary instabilities in market dynamics. This form does not yet have a generally accepted name. In Europe, the European Central Bank follows a more orthodox form of monetarism, with tighter controls over inflation and spending targets as mandated by the Economic and Monetary Union of the European Union under the Maastricht Treaty to support the euro.[12] This more orthodox monetary policy followed credit easing in the late 1980s through 1990s to fund German reunification, which was blamed for the weakening of European currencies in the late 1990s. Current state Since 1990, the classical form of monetarism has been questioned because of events that many economists have interpreted as being inexplicable in monetarist terms, namely the unhinging of the money supply growth from inflation in the 1990s and the failure of pure monetary policy to stimulate the economy in the 2001–2003 period. Alan Greenspan, former chairman of the Federal Reserve System, argued that the 1990s decoupling was explained by a virtuous cycle of productivity and investment on one hand, and a certain degree of "irrational exuberance" in the investment sector on the other. There are also arguments linking monetarism and macroeconomics, and treat monetarism as a special case of Keynesian theory. The central test case over the validity of these theories would be the possibility of a liquidity trap, like that experienced by Japan. Ben Bernanke, Princeton professor and former chairman of the U.S. Federal Reserve, has argued that monetary policy could respond to zero interest rate conditions by direct expansion of the money supply. In his words, "We have the keys to the printing press, and we are not afraid to use them." Progressive economist Paul Krugman has advanced the counterargument that this would have a corresponding devaluationary effect, like the sustained low interest rates of 2001–2004 produced against world currencies.[ These disagreements — along with the role of monetary policies in trade liberalisation, international investment and central bank policy — remain lively topics of investigation and argument.

Financial market A financial market is a market in which people trade financial securities, commodities, and other fungible items of value at low transaction costs and at prices that reflect supply and demand. Securities include stocks and bonds, and commodities include precious metals or agricultural goods. In economics, typically, the term market means the aggregate of possible buyers and sellers of a certain good or service and the transactions between them. The term "market" is sometimes used for what are more strictly exchanges, organizations that facilitate the trade in financial securities, e.g., a stock exchange or commodity exchange. This may be a physical location (like the NYSE, BSE, NSE) or an electronic system (like NASDAQ). Much trading of stocks takes place on an exchange; still, corporate actions (merger, spinoff) are outside an exchange, while any two companies or people, for whatever reason, may agree to sell stock from the one to the other without using an exchange. Trading of currencies and bonds is largely on a bilateral basis, although some bonds trade on a stock exchange, and people are building electronic systems for these as well, similar to stock exchanges. Types of financial markets Within the financial sector, the term "financial markets" is often used to refer just to the markets that are used to raise finance: for long term finance, the Capital markets; for short term finance, the Money markets. Another common use of the term is as a catchall for all the markets in the financial sector, as per examples in the breakdown below. •	Capital markets which consist of: o	Stock markets, which provide financing through the issuance of shares or common stock, and enable the subsequent trading thereof. o	Bond markets, which provide financing through the issuance of bonds, and enable the subsequent trading thereof. •	Commodity markets, which facilitate the trading of commodities. •	Money markets, which provide short term debt financing and investment. •	Derivatives markets, which provide instruments for the management of financial risk.[1] •	Futures markets, which provide standardized forward contracts for trading products at some future date; see also forward market. •	Insurance markets, which facilitate the redistribution of various risks. •	Foreign exchange markets, which facilitate the trading of foreign exchange.

The capital markets may also be divided into primary markets and secondary markets. Newly formed (issued) securities are bought or sold in primary markets, such as during initial public offerings. Secondary markets allow investors to buy and sell existing securities. The transactions in primary markets exist between issuers and investors, while secondary market transactions exist among investors.

Liquidity is a crucial aspect of securities that are traded in secondary markets. Liquidity refers to the ease with which a security can be sold without a loss of value. Securities with an active secondary market mean that there are many buyers and sellers at a given point in time. Investors benefit from liquid securities because they can sell their assets whenever they want; an illiquid security may force the seller to get rid of their asset at a large discount.

Raising capital Financial markets attract funds from investors and channel them to corporations—they thus allow corporations to finance their operations and achieve growth. Money markets allow firms to borrow funds on a short term basis, while capital markets allow corporations to gain long-term funding to support expansion (known as maturity transformation). Without financial markets, borrowers would have difficulty finding lenders themselves. Intermediaries such as banks, Investment Banks, and Boutique Investment Banks can help in this process. Banks take deposits from those who have money to save. They can then lend money from this pool of deposited money to those who seek to borrow. Banks popularly lend money in the form of loans and mortgages. More complex transactions than a simple bank deposit require markets where lenders and their agents can meet borrowers and their agents, and where existing borrowing or lending commitments can be sold on to other parties. A good example of a financial market is a stock exchange. A company can raise money by selling shares to investors and its existing shares can be bought or sold. The following table illustrates where financial markets fit in the relationship between lenders and borrowers: Relationship between lenders and borrowers Lenders	Financial Intermediaries Financial Markets	Borrowers Individuals Companies	Banks Insurance Companies Pension Funds Mutual Funds	Interbank Stock Exchange Money Market Bond Market Foreign Exchange	Individuals Companies Central Government Municipalities Public Corporations Lenders The lender temporarily gives money to somebody else, at the condition of getting back the principal amount together with some interest or charge. Individuals & Doubles Many individuals are not aware that they are lenders, but almost everybody does lend money in many ways. A person lends money when he or she: •	puts money in a savings account at a bank; •	contributes to a pension plan; •	pays premiums to an insurance company; •	invests in government bonds; Companies Companies tend to be borrowers of capital. When companies have surplus cash that is not needed for a short period of time, they may seek to make money from their cash surplus by lending it via short term markets called money markets. Alternatively, such companies may decide to return the cash surplus to their shareholders (e.g. via a share repurchase or dividend payment). Borrowers •	Individuals borrow money via bankers' loans for short term needs or longer term mortgages to help finance a house purchase. •	Companies borrow money to aid short term or long term cash flows. They also borrow to fund modernization or future business expansion. •	Governments often find their spending requirements exceed their tax revenues. To make up this difference, they need to borrow. Governments also borrow on behalf of nationalized industries, municipalities, local authorities and other public sector bodies. In the UK, the total borrowing requirement is often referred to as the Public sector net cash requirement (PSNCR). Governments borrow by issuing bonds. In the UK, the government also borrows from individuals by offering bank accounts and Premium Bonds. Government debt seems to be permanent. Indeed, the debt seemingly expands rather than being paid off. One strategy used by governments to reduce the value of the debt is to influence inflation. Municipalities and local authorities may borrow in their own name as well as receiving funding from national governments. In the UK, this would cover an authority like Hampshire County Council. Public Corporations typically include nationalized industries. These may include the postal services, railway companies and utility companies. Many borrowers have difficulty raising money locally. They need to borrow internationally with the aid of Foreign exchange markets. Borrowers having similar needs can form into a group of borrowers. They can also take an organizational form like Mutual Funds. They can provide mortgage on weight basis. The main advantage is that this lowers the cost of their borrowings. Derivative products During the 1980s and 1990s, a major growth sector in financial markets was the trade in so called derivative products, or derivatives for short. In the financial markets, stock prices, bond prices, currency rates, interest rates and dividends go up and down, creating risk. Derivative products are financial products which are used to control risk or paradoxically exploit risk.[2] It is also called financial economics. Derivative products or instruments help the issuers to gain an unusual profit from issuing the instruments. For using the help of these products a contract has to be made. Derivative contracts are mainly 4 types:[3] 1.	Future 2.	Forward 3.	Option 4.	Swap Currency markets Seemingly, the most obvious buyers and sellers of currency are importers and exporters of goods. While this may have been true in the distant past,[when?] when international trade created the demand for currency markets, importers and exporters now represent only 1/32 of foreign exchange dealing, according to the Bank for International Settlements.[4] The picture of foreign currency transactions today shows: •	Banks/Institutions •	Speculators •	Government spending (for example, military bases abroad) •	Importers/Exporters •	Tourists Analysis of financial markets Much effort has gone into the study of financial markets and how prices vary with time. Charles Dow, one of the founders of Dow Jones & Company and The Wall Street Journal, enunciated a set of ideas on the subject which are now called Dow theory. This is the basis of the so-called technical analysis method of attempting to predict future changes. One of the tenets of "technical analysis" is that market trends give an indication of the future, at least in the short term. The claims of the technical analysts are disputed by many academics, who claim that the evidence points rather to the random walk hypothesis, which states that the next change is not correlated to the last change. The role of human psychology in price variations also plays a significant factor. Large amounts of volatility often indicate the presence of strong emotional factors playing into the price. Fear can cause excessive drops in price and greed can create bubbles. In recent years the rise of algorithmic and high-frequency program trading has seen the adoption of momentum, ultra-short term moving average and other similar strategies which are based on technical as opposed to fundamental or theoretical concepts of market Behaviour. The scale of changes in price over some unit of time is called the volatility. It was discovered by Benoît Mandelbrot that changes in prices do not follow a Gaussian distribution, but are rather modeled better by Lévy stable distributions. The scale of change, or volatility, depends on the length of the time unit to a power a bit more than 1/2. Large changes up or down are more likely than what one would calculate using a Gaussian distribution with an estimated standard deviation. Financial market slang •	Poison pill, when a company issues more shares to prevent being bought out by another company, thereby increasing the number of outstanding shares to be bought by the hostile company making the bid to establish majority. •	Quant, a quantitative analyst with advanced training in mathematics and statistical methods. •	Rocket scientist, a financial consultant at the zenith of mathematical and computer programming skill. They are able to invent derivatives of high complexity and construct sophisticated pricing models. They generally handle the most advanced computing techniques adopted by the financial markets since the early 1980s. Typically, they are physicists and engineers by training. •	White Knight, a friendly party in a takeover bid. Used to describe a party that buys the shares of one organization to help prevent against a hostile takeover of that organization by another party. •	round-tripping •	smurfing, a deliberate structuring of payments or transactions to conceal it from regulators or other parties, a type of money laundering that is often illegal. •	Spread, the difference between the highest bid and the lowest offer.

Role (Financial system and the economy) One of the important sustainability requisite for the accelerated development of an economy is the existence of a dynamic financial market. A financial market helps the economy in the following manner. •	Saving mobilization: Obtaining funds from the savers or surplus units such as household individuals, business firms, public sector units, central government, state governments etc. is an important role played by financial markets. •	Investment: Financial markets play a crucial role in arranging to invest funds thus collected in those units which are in need of the same. •	National Growth: An important role played by financial market is that, they contribute to a nation's growth by ensuring unfettered flow of surplus funds to deficit units. Flow of funds for productive purposes is also made possible. •	Entrepreneurship growth: Financial market contribute to the development of the entrepreneurial claw by making available the necessary financial resources. •	Industrial development: The different components of financial markets help an accelerated growth of industrial and economic development of a country, thus contributing to raising the standard of living and the society of well-being.

Functions of Financial Markets •	Intermediary Functions: The intermediary functions of a financial markets include the following: o	Transfer of Resources: Financial markets facilitate the transfer of real economic resources from lenders to ultimate borrowers. o	Enhancing income: Financial markets allow lenders to earn interest or dividend on their surplus invisible funds, thus contributing to the enhancement of the individual and the national income. o	Productive usage: Financial markets allow for the productive use of the funds borrowed. The enhancing the income and the gross national production. o	Capital Formation: Financial markets provide a channel through which new savings flow to aid capital formation of a country. o	Price determination: Financial markets allow for the determination of price of the traded financial assets through the interaction of buyers and sellers. They provide a sign for the allocation of funds in the economy based on the demand and to the supply through the mechanism called price discovery process. o	Sale Mechanism: Financial markets provide a mechanism for selling of a financial asset by an investor so as to offer the benefit of marketability and liquidity of such assets. o	Information: The activities of the participants in the financial market result in the generation and the consequent dissemination of information to the various segments of the market. So as to reduce the cost of transaction of financial assets. •	Financial Functions o	Providing the borrower with funds so as to enable them to carry out their investment plans. o	Providing the lenders with earning assets so as to enable them to earn wealth by deploying the assets in production debentures. o	Providing liquidity in the market so as to facilitate trading of funds. o	Providing liquidity to commercial bank o	Facilitating credit creation o	Promoting savings o	Promoting investment o	Facilitating balanced economic growth o	Improving trading floors

Constituents of Financial Market Based on market levels •	Primary market: Primary market is a market for new issues or new financial claims. Hence it’s also called new issue market. The primary market deals with those securities which are issued to the public for the first time. •	Secondary market: It’s a market for secondary sale of securities. In other words, securities which have already passed through the new issue market are traded in this market. Generally, such securities are quoted in the stock exchange and it provides a continuous and regular market for buying and selling of securities. Simply put, primary market is the market where the newly started company issued shares to the public for the first time through IPO (initial public offering). Secondary market is the market where the second hand securities are sold (security Commodity Marketies). Based on security types •	Money market: Money market is a market for dealing with financial assets and securities which have a maturity period of up to one year. In other words, it’s a market for purely short term funds. •	Capital market: A capital market is a market for financial assets which have a long or indefinite maturity. Generally it deals with long term securities which have a maturity period of above one year. Capital market may be further divided into: (a) industrial securities market (b) Govt. securities market and (c) long term loans market. o	Equity markets: A market where ownership of securities are issued and subscribed is known as equity market. An example of a secondary equity market for shares is the Bombay stock exchange. o	Debt market: The market where funds are borrowed and lent is known as debt market. Arrangements are made in such a way that the borrowers agree to pay the lender the original amount of the loan plus some specified amount of interest. •	Derivative markets: A market where financial instruments are derived and traded based on an underlying asset such as commodities or stocks. •	Financial service market: A market that comprises participants such as commercial banks that provide various financial services like ATM. Credit cards. Credit rating, stock broking etc. is known as financial service market. Individuals and firms use financial services markets, to purchase services that enhance the working of debt and equity markets. •	Depository markets: A depository market consist of depository institutions that accept deposit from individuals and firms and uses these funds to participate in the debt market, by giving loans or purchasing other debt instruments such as treasure bills. •	Non-Depository market: Non-depository market carry out various functions in financial markets ranging from financial intermediary to selling, insurance etc. The various constituency in non-depositary markets are mutual funds, insurance companies, pension funds, brokerage firms etc.

Capital market Capital markets are financial markets for the buying and selling of long-term debt or equity-backed securities. These markets channel the wealth of savers to those who can put it to long-term productive use, such as companies or governments making long-term investments. Capital markets are defined as markets in which money is provided for periods longer than a year. Financial regulators, such as the UK's Bank of England (BoE) or the U.S. Securities and Exchange Commission (SEC), oversee the capital markets in their jurisdictions to protect investors against fraud, among other duties.

Modern capital markets are almost invariably hosted on computer-based electronic trading systems; most can be accessed only by entities within the financial sector or the treasury departments of governments and corporations, but some can be accessed directly by the public.[3] There are many thousands of such systems, most serving only small parts of the overall capital markets. Entities hosting the systems include stock exchanges, investment banks, and government departments. Physically the systems are hosted all over the world, though they tend to be concentrated in financial centres like London, New York, and Hong Kong.

A key division within the capital markets is between the primary markets and secondary markets. In primary markets, new stock or bond issues are sold to investors, often via a mechanism known as underwriting. The main entities seeking to raise long-term funds on the primary capital markets are governments (which may be municipal, local or national) and business enterprises (companies). Governments tend to issue only bonds, whereas companies often issue either equity or bonds. The main entities purchasing the bonds or stock include pension funds, hedge funds, sovereign wealth funds, and less commonly wealthy individuals and investment banks trading on their own behalf. In the secondary markets, existing securities are sold and bought among investors or traders, usually on an exchange, over-the-counter, or elsewhere. The existence of secondary markets increases the willingness of investors in primary markets, as they know they are likely to be able to swiftly cash out their investments if the need arises. A second important division falls between the stock markets (for equity securities, also known as shares, where investors acquire ownership of companies) and the bond markets (where investors become creditors).[4] Difference between money markets and capital markets The money markets are used for the raising of short term finance, sometimes for loans that are expected to be paid back as early as overnight. Whereas the capital markets are used for the raising of long term finance, such as the purchase of shares, or for loans that are not expected to be fully paid back for at least a year.[2] Funds borrowed from the money markets are typically used for general operating expenses, to cover brief periods of illiquidity. For example a company may have inbound payments from customers that have not yet cleared, but may wish to immediately pay out cash for its payroll. When a company borrows from the primary capital markets, often the purpose is to invest in additional physical capital goods, which will be used to help increase its income. It can take many months or years before the investment generates sufficient return to pay back its cost, and hence the finance is long term.[4] Together, money markets and capital markets form the financial markets as the term is narrowly understood.[5] The capital market is concerned with long term finance. In the widest sense, it consists of a series of channels through which the savings of the community are made available for industrial and commercial enterprises and public authorities.

Difference between regular bank lending and capital markets Regular bank lending is not usually classed as a capital market transaction, even when loans are extended for a period longer than a year. A key difference is that with a regular bank loan, the lending is not securitized (i.e., it doesn't take the form of resalable security like a share or bond that can be traded on the markets). A second difference is that lending from banks and similar institutions is more heavily regulated than capital market lending. A third difference is that bank depositors and shareholders tend to be more risk averse than capital market investors. The previous three differences all act to limit institutional lending as a source of finance. Two additional differences, this time favoring lending by banks, are that banks are more accessible for small and medium companies, and that they have the ability to create money as they lend. In the 20th century, most company finance apart from share issues was raised by bank loans. But since about 1980 there has been an ongoing trend for disintermediation, where large and credit worthy companies have found they effectively have to pay out less in interest if they borrow direct from capital markets rather than banks. The tendency for companies to borrow from capital markets instead of banks has been especially strong in the US. According to Lena Komileva writing for The Financial Times, Capital Markets overtook bank lending as the leading source of long term finance in 2009 - this reflects the additional risk aversion and regulation of banks following the 2008 financial crisis. Examples of capital market transactions A government raising money on the primary markets When a government wants to raise long term finance it will often sell bonds to the capital markets. In the 20th and early 21st century, many governments would use investment banks to organize the sale of their bonds. The leading bank would underwrite the bonds, and would often head up a syndicate of brokers, some of whom might be based in other investment banks. The syndicate would then sell to various investors. For developing countries, a multilateral development bank would sometimes provide an additional layer of underwriting, resulting in risk being shared between the investment bank(s), the multilateral organization, and the end investors. However, since 1997 it has been increasingly common for governments of the larger nations to bypass investment banks by making their bonds directly available for purchase over the Internet. Many governments now sell most of their bonds by computerized auction. Typically large volumes are put up for sale in one go; a government may only hold a small number of auctions each year. Some governments will also sell a continuous stream of bonds through other channels. The biggest single seller of debt is the US Government; there are usually several transactions for such sales every second,[7] which corresponds to the continuous updating of the US real time debt clock.[8][9][10] A company raising money on the primary markets When a company wants to raise money for long-term investment, one of its first decisions is whether to do so by issuing bonds or shares. If it chooses shares, it avoids increasing its debt, and in some cases the new shareholders may also provide non monetary help, such as expertise or useful contacts. On the other hand, a new issue of shares can dilute the ownership rights of the existing shareholders, and if they gain a controlling interest, the new shareholders may even replace senior managers. From an investor's point of view, shares offer the potential for higher returns and capital gains if the company does well. Conversely, bonds are safer if the company does poorly, as they are less prone to severe falls in price, and in the event of bankruptcy, bond owners are usually paid before shareholders. When a company raises finance from the primary market, the process is more likely to involve face-to-face meetings than other capital market transactions. Whether they choose to issue bonds or shares,[11] companies will typically enlist the services of an investment bank to mediate between themselves and the market. A team from the investment bank often meets with the company's senior managers to ensure their plans are sound. The bank then acts as an underwriter, and will arrange for a network of brokers to sell the bonds or shares to investors. This second stage is usually done mostly through computerized systems, though brokers will often phone up their favored clients to advise them of the opportunity. Companies can avoid paying fees to investment banks by using a direct public offering, though this is not a common practice as it incurs other legal costs and can take up considerable management time.[8][12] Trading on the secondary markets An Electronic trading platform being used at the Deutsche Börse. Most 21st century capital market transactions are executed electronically, sometimes a human operator is involved, and sometimes unattended computer systems execute the transactions, as happens in algorithmic trading. Most capital market transactions take place on the secondary market. On the primary market, each security can be sold only once, and the process to create batches of new shares or bonds is often lengthy due to regulatory requirements. On the secondary markets, there is no limit on the number of times a security can be traded, and the process is usually very quick. With the rise of strategies such as high-frequency trading, a single security could in theory be traded thousands of times within a single hour.[13] Transactions on the secondary market don't directly help raise finance, but they do make it easier for companies and governments to raise finance on the primary market, as investors know if they want to get their money back in a hurry, they will usually be easily able to re-sell their securities. Sometimes however secondary capital market transactions can have a negative effect on the primary borrowers - for example, if a large proportion of investors try to sell their bonds, this can push up the yields for future issues from the same entity. An extreme example occurred shortly after Bill Clinton began his first term as President of the United States; Clinton was forced to abandon some of the spending increases he'd promised in his election campaign due to pressure from the bond markets. In the 21st century, several governments have tried to lock in as much as possible of their borrowing into long dated bonds, so they are less vulnerable to pressure from the markets. Following the financial crisis of 2007–08, the introduction of Quantitative easing further reduced the ability of private actors to push up the yields of government bonds, at least for countries with a Central bank able to engage in substantial Open market operations. [8][10][12] [14] A variety of different players are active in the secondary markets. Regular individuals account for a small proportion of trading, though their share has slightly increased; in the 20th century it was mostly only a few wealthy individuals who could afford an account with a broker, but accounts are now much cheaper and accessible over the internet. There are now numerous small traders who can buy and sell on the secondary markets using platforms provided by brokers which are accessible via web browsers. When such an individual trades on the capital markets, it will often involve a two-stage transaction. First they place an order with their broker, then the broker executes the trade. If the trade can be done on an exchange, the process will often be fully automated. If a dealer needs to manually intervene, this will often mean a larger fee. Traders in investment banks will often make deals on their bank's behalf, as well as executing trades for their clients. Investment banks will often have a division (or department) called capital markets: staff in this division try to keep aware of the various opportunities in both the primary and secondary markets, and will advise major clients accordingly. Pension and sovereign wealth funds tend to have the largest holdings, though they tend to buy only the highest grade (safest) types of bonds and shares, and often don't trade all that frequently. According to a 2012 Financial Times article, hedge funds are increasingly making most of the short term trades in large sections of the capital market (like the UK and US stock exchanges), which is making it harder for them to maintain their historically high returns, as they are increasingly finding themselves trading with each other rather than with less sophisticated investors.[8][10][12][15] There are several ways to invest in the secondary market without directly buying shares or bonds. A common method is to invest in mutual funds[16] or exchange-traded funds. It's also possible to buy and sell derivatives that are based on the secondary market; one of the most common being contract for difference - these can provide rapid profits, but can also cause buyers to lose more money than they originally invested.[8] Size of the global capital markets All figures given are in Billions of US$ and are sourced to the IMF. There is no universally recognized standard for measuring all of these figures, so other estimates may vary. A GDP column is included as a comparison. Year[17] Stocks	Bonds	Bank assets[18] Total of stocks, bonds and bank assets.[19] World GDP 2013[20] 62,552.00	99,788.80	120,421.60	282,762.40	74,699.30 2012[21] 52,494.90	99,134.20	116,956.10	268,585.20	72,216.40 2011[22] 47,089.23	98,388.10	110,378.24	255,855.57	69,899.22 Capital controls Capital controls are measures imposed by a state's government aimed at managing capital account transactions - in other words, capital market transactions where one of the counter-parties[23] involved is in a foreign country. Whereas domestic regulatory authorities try to ensure that capital market participants trade fairly with each other, and sometimes to ensure institutions like banks don't take excessive risks, capital controls aim to ensure that the macroeconomic effects of the capital markets don't have a net negative impact on the nation in question. Most advanced nations like to use capital controls sparingly if at all, as in theory allowing markets freedom is a win-win situation for all involved: investors are free to seek maximum returns, and countries can benefit from investments that will develop their industry and infrastructure. However sometimes capital market transactions can have a net negative effect - for example, in a financial crisis, there can be a mass withdrawal of capital, leaving a nation without sufficient foreign currency to pay for needed imports. On the other hand, if too much capital is flowing into a country, it can push up inflation and the value of the nation's currency, making its exports uncompetitive. Some nations such as India have also used capital controls to ensure that their citizens' money is invested at home, rather than abroad.

Money market As money became a commodity, the money market became a component of the financial markets for assets involved in short-term borrowing, lending, buying and selling with original maturities of one year or less. Trading in money markets is done over the counter and is wholesale. There are several money market instruments, including treasury bills, commercial paper, bankers' acceptances, deposits, certificates of deposit, bills of exchange, repurchase agreements, federal funds, and short-lived mortgage-, and asset-backed securities. The instruments bear differing maturities, currencies, credit risks, and structure and thus may be used to distribute exposure. Money markets, which provide liquidity for the global financial system, and capital markets make up the financial market. Participants The money market consists of financial institutions and dealers in money or credit who wish to either borrow or lend. Participants borrow and lend for short periods, typically up to thirteen months. Money market trades in short-term financial instruments commonly called "paper". This contrasts with the capital market for longer-term funding, which is supplied by bonds and equity. The core of the money market consists of interbank lending—banks borrowing and lending to each other using commercial paper, repurchase agreements and similar instruments. These instruments are often benchmarked to (i.e., priced by reference to) the London Interbank Offered Rate (LIBOR) for the appropriate term and currency. Finance companies typically fund themselves by issuing large amounts of asset-backed commercial paper (ABCP) which is secured by the pledge of eligible assets into an ABCP conduit. Examples of eligible assets include auto loans, credit card receivables, residential/commercial mortgage loans, mortgage-backed securities and similar financial assets. Some large corporations with strong credit ratings, such as General Electric, issue commercial paper on their own credit. Other large corporations arrange for banks to issue commercial paper on their behalf. In the United States, federal, state and local governments all issue paper to meet funding needs. States and local governments issue municipal paper, while the U.S. Treasury issues Treasury bills to fund the U.S. public debt: •	Trading companies often purchase bankers' acceptances to be tendered for payment to overseas suppliers. •	Retail and institutional money market funds •	Banks •	Central banks •	Cash management programs •	Merchant banks Functions of the money market Money markets serve five functions—to finance trade, finance industry, invest profitably, enhance commercial banks' self-sufficiency, and lubricate central bank policies.[3][4] Financing trade The money market plays crucial role in financing domestic and international trade. Commercial finance is made available to the traders through bills of exchange, which are discounted by the bill market. The acceptance houses and discount markets help in financing foreign trade. Financing industry The money market contributes to the growth of industries in two ways: •	They help industries secure short-term loans to meet their working capital requirements through the system of finance bills, commercial papers, etc. •	Industries generally need long-term loans, which are provided in the capital market. However, the capital market depends upon the nature of and the conditions in the money market. The short-term interest rates of the money market influence the long-term interest rates of the capital market. Thus, money market indirectly helps the industries through its link with and influence on long-term capital market. Profitable investment The money market enables the commercial banks to use their excess reserves in profitable investment. The main objective of the commercial banks is to earn income from its reserves as well as maintain liquidity to meet the uncertain cash demand of the depositors. In the money market, the excess reserves of the commercial banks are invested in near-money assets (e.g., short-term bills of exchange) which are highly liquid and can be easily converted into cash. Thus, the commercial banks earn profits without sacrificing liquidity. Self-sufficiency of commercial bank Developed money markets help the commercial banks to become self-sufficient. In the situation of emergency, when the commercial banks have scarcity of funds, they need not approach the central bank and borrow at a higher interest rate. On the other hand, they can meet their requirements by recalling their old short-run loans from the money market. Help to central bank Though the central bank can function and influence the banking system in the absence of a money market, the existence of a developed money market smoothens the functioning and increases the efficiency of the central bank. Money markets help central banks in two ways: •	Short-run interest rates serve as an indicator of the monetary and banking conditions in the country and, in this way, guide the central bank to adopt an appropriate banking policy, •	Sensitive and integrated money markets help the central bank secure quick and widespread influence on the sub-markets, thus facilitating effective policy implementation Money market instruments •	Certificate of deposit – Time deposit, commonly offered to consumers by banks, thrift institutions, and credit unions. •	Repurchase agreements – Short-term loans—normally for less than two weeks and frequently for one day—arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date. •	Commercial paper – Short term usanse promissory notes issued by company at discount to face value and redeemed at face value •	Eurodollar deposit – Deposits made in U.S. dollars at a bank or bank branch located outside the United States. •	Federal agency short-term securities – In the U.S., short-term securities issued by government sponsored enterprises such as the Farm Credit System, the Federal Home Loan Banks and the Federal National Mortgage Association. •	Federal funds – In the U.S., interest-bearing deposits held by banks and other depository institutions at the Federal Reserve; these are immediately available funds that institutions borrow or lend, usually on an overnight basis. They are lent for the federal funds rate. •	Municipal notes – In the U.S., short-term notes issued by municipalities in anticipation of tax receipts or other revenues. •	Treasury bills – Short-term debt obligations of a national government that are issued to mature in three to twelve months. •	Money funds – Pooled short-maturity, high-quality investments which buy money market securities on behalf of retail or institutional investors. •	Foreign exchange swaps – Exchanging a set of currencies in spot date and the reversal of the exchange of currencies at a predetermined time in the future. •	Short-lived mortgage- and asset-backed securities Discount and accrual instruments There are two types of instruments in the fixed income market that pay interest at maturity, instead of as coupons—discount instruments and accrual instruments. Discount instruments, like repurchase agreements, are issued at a discount of face value, and their maturity value is the face value. Accrual instruments are issued at face value and mature at face value plus interest.

Flow of Funds Flow of funds accounts are a system of interrelated balance sheets for a nation, calculated periodically. There are two types of balance sheets: those showing •	The aggregate assets and liabilities for financial and nonfinancial sectors, and •	What sectors issue and hold financial assets (instruments) of a given type.

The sectors and instruments are listed below. These balance sheets measure levels of assets and liabilities. From each balance sheet a corresponding flows statement can be derived by subtracting the levels data for the preceding period from the data for the current period. (In the statistical analysis of time series, this operation is known as "first differencing.") The change in a level item between two adjacent periods is known as a "fund flow"; hence the name for these accounts.

Main topics covered in the FF accounts •	Total debt broken down by issuer and holder •	Connection to national accounts, and derivation of measures of aggregate saving •	Fund flows originating in each sector •	Levels: o	Assets and liabilities for broad sectors and for specific financial sectors o	Sectors issuing and holding instruments of a given class •	Miscellaneous aggregate financial data Organization of the flow of funds accounts of the US The flow of funds (FOF) accounts of the United States are prepared by the Flow of Funds section of the Board of Governors of the Federal Reserve System, and published quarterly in a publication called the Z.1 Statistical Release. Current and historical releases available in pdf, csv, or xml format. Data frequency is annual from yearend 1945 and quarterly beginning in 1952Q1. Detailed interactive documentation is also available. The flow of funds accounts follow naturally from double-entry bookkeeping; every financial asset is also a liability of some domestic or foreign human entity. A fundamental fact about any economic sector is its balance sheet, a breakdown of its physical and financial assets, and of its liabilities. The only physical assets noted in the FF accounts are those of private nonfinancial sectors. Broad structure of the US economy Nonfinancial sectors: •	Households and nonprofit organizations •	Nonfinancial firms o	Corporations, farms excepted o	Unincorporated firms, farms excepted o	Farms •	Government o	Federal o	State & local •	Rest of the world (foreign sector) Financial sector: •	Firms •	Instruments Firms •	Federal Reserve System •	Depository institutions: o	US chartered commercial banks o	Branch offices of foreign banks o	Bank holding companies o	Banks in US possessions o	Thrifts o	Credit unions •	Property-casualty insurance •	Life insurance •	Pension funds: o	Federal government o	State & local government o	Private employers •	Money market funds •	Other open-ended mutual funds •	Exchange-traded funds & closed-end funds •	Government-sponsored enterprises (GSEs) •	Federal mortgage pools •	Issuers of asset-backed securities •	Finance companies •	Real estate investment trusts •	Security brokers & dealers •	Funding corporations Instruments (asset types) •	Official reserve assets •	Treasury currency and SDRs •	American-owned deposits in other countries •	Net interbank transactions •	Checkable deposits & Fed currency •	Time & savings deposits •	Money market fund shares •	Federal funds & Repos •	Privately issued short-term paper •	Treasury securities •	Agency & GSE-backed securities •	Municipal bonds & related debt •	Corporate & foreign bonds •	Corporate equities •	Mutual fund shares •	Mortgages: o	Home (single family residence) o	Multifamily residence o	Commercial o	Farm •	Consumer credit •	Other bank loans •	Trade credit •	Security credit •	Other loans & advances •	Reserves of life insurance companies & pension funds •	Taxes payable •	Proprietors' equity in unincorporated firms •	Miscellaneous financial assets Organization of the flow of funds accounts of the UK The UK flow of funds accounts are prepared by the Office for National Statistics in a series of matrices. The first tables will be published in Blue Book 2014, to be released in September 2014. They contain the sectors and instruments shown below: Sectors •	Public Corporations •	Private non-Financial Corporations •	Monetary Financial Institutions •	Other Financial Institutions •	Insurance Corporations and Pension Funds •	Central Government •	Local Government •	Households and NPISH •	UK total economy •	Rest of the World Financial Instruments Monetary Gold and Special Drawing Rights Currency and Deposits •	Currency •	Transferable Deposits o	With UK MFIs o	With Rest of the World MFIs •	Other deposits Debt securities •	Short term debt securities issued o	by UK Central Government o	by UK Local Government o	by UK MFIs o	MMIs by other UK residents o	MMIs by rest of the world •	Long term debt securities issued o	by UK Central Government o	by UK Local Government o	Medium term bonds by UK MFIs o	Medium and long-term bonds by other UK residents o	Long term bonds by rest of the world Loans •	Short term loans o	by UK MFIs o	by ROW MFIs •	Long term loans o	Direct Investment loans o	Secured on dwellings o	Finance leasing o	Other long term loans by UK residents o	Other long term loans by rest of the world Equity and investment fund shares/units •	Shares and other equity, excluding mutual funds shares o	Listed UK shares o	Unlisted UK shares o	Other UK equity o	UK shares and bonds issued by other UK residents o	Shares and other equity issued by the rest of the world •	Investment fund shares/units o	UK investment funds' shares o	Rest of the world mutual funds' shares Insurance technical reserves •	Non-life insurance technical reserves •	Life insurance and annuity entitlements •	Pension schemes •	Provisions for calls under standardized guarantees Financial derivates and employee stock options •	of which; Financial Derivatives

Demand for money The demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits. It can refer to the demand for money narrowly defined as M1 (non-interest-bearing holdings), or for money in the broader sense of M2 or M3.

Money in the sense of M1 is dominated as a store of value by interest-bearing assets. However, money is necessary to carry out transactions; in other words, it provides liquidity. This creates a trade-off between the liquidity advantage of holding money and the interest advantage of holding other assets. The demand for money is a result of this trade-off regarding the form in which a person's wealth should be held. In macroeconomics motivations for holding one's wealth in the form of money can roughly be divided into the transaction motive and the asset motive. These can be further subdivided into more micro economically founded motivations for holding money. Generally, the nominal demand for money increases with the level of nominal output (price level times real output) and decreases with the nominal interest rate. The real demand for money is defined as the nominal amount of money demanded divided by the price level. For a given money supply the locus of income-interest rate pairs at which money demand equals money supply is known as the LM curve.

The magnitude of the volatility of money demand has crucial implications for the optimal way in which a central bank should carry out monetary policy and its choice of a nominal anchor. Conditions under which the LM curve is flat, so that increases in the money supply have no stimulatory effect (a liquidity trap), play an important role in Keynesian theory. This situation occurs when the demand for money is infinitely elastic with respect to the interest rate. A typical money-demand function may be written as where is the nominal amount of money demanded, P is the price level, R is the nominal interest rate, Y is real output, and L(.) is real money demand. An alternate name for is the liquidity preference function. Motives for holding money Transaction motive The transactions motive for money demand results from the need for liquidity for day-to-day transactions in the near future. This need arises when income is received only occasionally (say once per month) in discrete amounts but expenditures occur continuously. Quantity theory The most basic "classical" transaction motive can be illustrated with reference to the Quantity Theory of Money. According to the equation of exchange MV = PY, where M is the stock of money, V is its velocity (how many times a unit of money turns over during a period of time), P is the price level and Y is real income. Consequently PY is nominal income or in other words the number of transactions carried out in an economy during a period of time. Rearranging the above identity and giving it a behavioral interpretation as a demand for money we have or in terms of demand for real balances Hence in this simple formulation demand for money is a function of prices and income, as long as its velocity is constant. Inventory models The amount of money demanded for transactions however is also likely to depend on the nominal interest rate. This arises due the lack of synchronization in time between when purchases are desired and when factor payments (such as wages) are made. In other words, while workers may get paid only once a month they generally will wish to make purchases, and hence need money, over the course of the entire month. The most well-known example of an economic model that is based on such considerations is the Baumol-Tobin model. In this model an individual receives her income periodically, for example, only once per month, but wishes to make purchases continuously. The person could carry her entire income with her at all times and use it to make purchases. However, in this case she would be giving up the (nominal) interest rate that she can get by holding her income in the bank. The optimal strategy involves holding a portion of one's income in the bank and portion as liquid money. The money portion is continuously run down as the individual makes purchases and then she makes periodic (costly) trips to the bank to replenish the holdings of money. Under some simplifying assumptions the demand for money resulting from the Baumol-Tobin model is given by where t is the cost of a trip to the bank, R is the nominal interest rate and P and Y are as before. The key difference between this formulation and the one based on a simple version of Quantity Theory is that now the demand for real balances depends on both income (positively) or the desired level of transactions, and on the nominal interest rate (negatively). Micro foundations for money demand While the Baumol–Tobin model provides a microeconomic explanation for the form of the money demand function, it is generally too stylized to be included in modern macroeconomic models, particularly dynamic stochastic general equilibrium models. As a result most models of this type resort to simpler indirect methods which capture the spirit of the transactions motive. The two most commonly used methods are the cash-in-advance model (sometimes called the Clower constraint model) and the money-in-the-utility-function (MIU) model (as known as the Sidrauski model).[1] In the cash-in-advance model agents are restricted to carrying out a volume of transactions equal to or less than their money holdings. In the MIU model, money directly enters agents' utility functions, capturing the 'liquidity services' provided by money.[2] Asset motive The asset motive treats money, in the broader sense of including interest-bearing bank deposits, as a particular type of a financial asset among many others. While it is still assumed that money is held in order to carry out transactions, this approach focuses on the potential return on various assets (including money) as an additional motivation. Speculative motive John Maynard Keynes, in laying out speculative reasons for holding money, stressed the choice between money and bonds. If agents expect the future nominal interest rate (the return on bonds) to be lower than the current rate they will then reduce their holdings of money and increase their holdings of bonds. If the future interest rate does fall, then the price of bonds will increase and the agents will have realized a capital gain on the bonds they purchased. This means that the demand for money in any period will depend on both the current nominal interest rate and the expected future interest rate (in addition to the standard transaction motives which depend on income). The fact that the current demand for money can depend on expectations of the future interest rates has implications for volatility of money demand. If these expectations are formed, as in Keynes' view, by "animal spirits" they are likely to change erratically and cause money demand to be quite unstable. Portfolio motive The portfolio motive also focuses on demand for money over and above that required for carrying out transactions. The basic framework is due to James Tobin, who considered a situation where agents can hold their wealth in a form of a low risk/low return asset (here, money) or high risk/high return asset (bonds or equity). Agents will choose a mix of these two types of assets (their portfolio) based on the risk-expected return trade-off. For a given expected rate of return, more risk averse individuals will choose a greater share for money in their portfolio. Similarly, given a person's degree of risk aversion, a higher expected return (nominal interest rate plus expected capital gains on bonds) will cause agents to shift away from safe money and into risky assets. Like in the other motivations above, this creates a negative relationship between the nominal interest rate and the demand for money. However, what matters additionally in the Tobin model is the subjective rate of risk aversion, as well as the objective degree of risk of other assets, as, say, measured by the standard deviation of capital gains and losses resulting from holding bonds and/or equity. Empirical estimations of money demand functions Is money demand stable? Friedman and Schwartz in their 1963 work A Monetary History of the United States argued that the demand for real balances was a stable function of income and the interest rate. For the time period they were studying this appeared to be true. However, shortly after the publication of the book, due to changes in financial markets and financial regulation money demand became more unstable. Various researchers showed that money demand became much more unstable after 1975. Ericsson, Hendry and Prestwich (1998) consider a model of money demand based on the various motives outlined above and test it with empirical data. The basic model turns out to work well for the period 1878 to 1975 and there doesn't appear to be much volatility in money demand, in a result analogous to that of Friedman and Schwartz. This is true even despite the fact that the two world wars during this time period could have led to changes in the velocity of money. However, when the same basic model is used on data spanning 1976 to 1993, it performs poorly. In particular, money demand appears not to be sensitive to interest rates and there appears to be much more exogenous volatility. The authors attribute the difference to technological innovations in the financial markets, financial deregulation, and the related issue of the changing menu of assets considered in the definition of money. Later work by Lawrence Ball suggests that the use of adapted aggregates, such as near monies, can produce a more stable demand function. Through his research, Ball was able to show that using the return on near monies produced smaller deviations than previous models. Importance of money demand volatility for monetary policy If the demand for money is stable then a monetary policy which consists of a monetary rule which targets the growth rate of some monetary aggregate (such as M1 or M2) can help to stabilize the economy or at least remove monetary policy as a source of macroeconomic volatility. Additionally, if the demand for money does not change unpredictably then money supply targeting is a reliable way of attaining a constant inflation rate. This can be most easily seen with the quantity theory of money equation given above. When that equation is converted into growth rates we have which says that the growth rate of money supply plus the growth rate of its velocity equals the inflation rate plus the growth rate of real output. If money demand is stable then velocity is constant and. Additionally, in the long run real output grows at a constant rate equal to the sum of the rates of growth of population, technological know-how, and technology in place, and as such is exogenous. In this case the above equation can be solved for the inflation rate: Here, given the long-run output growth rate, the only determinant of the inflation rate is the growth rate of the money supply. In this case inflation in the long run is a purely monetary phenomenon; a monetary policy which targets the money supply can stabilize the economy and ensure a non-variable inflation rate. This analysis however breaks down if the demand for money is not stable — for example, if velocity in the above equation is not constant. In that case, shocks to money demand under money supply targeting will translate into changes in real and nominal interest rates and result in economic fluctuations. An alternative policy of targeting interest rates rather than the money supply can improve upon this outcome as the money supply is adjusted to shocks in money demand, keeping interest rates (and hence, economic activity) relatively constant. The above discussion implies that the volatility of money demand matters for how monetary policy should be conducted. If most of the aggregate demand shocks which affect the economy come from the expenditure side, the IS curve, then a policy of targeting the money supply will be stabilizing, relative to a policy of targeting interest rates. However, if most of the aggregate demand shocks come from changes in money demand, which influences the LM curve, then a policy of targeting the money supply will be destabilizing.