Monetary theory, an important subarea of macroeconomics, proposes to explain the relationship between the money stock and the macroeconomic system. Macroeconomics is the part of economics concerned with the economy as a whole, as opposed to individual industries or sectors. Fluctuations in the economy as a whole, that is, in aggregate output, cause fluctuations in the unemployment rate, interest rates, and average prices.

Monetary theory analyses the role of money in the macroeconomic system in terms of the demand for money, supply of money, and the natural tendency of the economic system to adjust to a point that balances the supply and demand for money, a point that is called monetary equilibrium. One sector of the macroeconomic system is conceived as the monetary sector, and the monetary sector has a natural tendency to converge to monetary equilibrium.

A phenomenon such as inflation can be attributed to an excess of the supply of money relative to the demand. Excess money supply causes the value of money to drop, which manifests itself as higher prices, causing each unit of money to buy less. A stock market crash can be attributed to an excess demand for money relative to supply, causing stockholders to sell stocks to raise money. Theoretically, the macroeconomic system converges to equilibrium and one necessary condition for macroeconomic equilibrium is monetary equilibrium.

Monetary theory usually assumes as a rough approximation that the money supply is fixed by monetary authorities, and can be changed as necessary for the public’s interest. The demand for money, however, is outside the control of public officials and is a function of other economic variables, particularly aggregate income, interest rates, the price level, and inflation. Aggregate income determines the amount of money households and businesses plan to spend in the near future. Households and businesses hold money because they plan to buy things in the near future.

Money holdings of households and businesses that will not be needed for purchases in the near future may be invested in long-term assets (stocks and bonds) that earn income. Money holdings earn little or no income. When money holdings are used to purchase stocks and bonds, the demand for money decreases, and the demand for stocks and bonds increases. Rising interest rates decrease money demand as money holdings are drawn into the purchase of bonds. Falling interest rates cause bonds to become less attractive, raising the demand for money.

Like rising interest rates, inflation means that money can be put to better use in other places, perhaps in the purchase of gold, silver, or real estate. Inflation reduces the demand for money, but deflation makes hoarding money an attractive investment, increasing the demand for money. Higher price levels, however, will eventually increase the demand for money, as money is needed to finance more costly transactions. Inflation reduces the demand for money at first, but when the inflation ceases, the demand for money will level out at a higher level than existed before the inflation started.

When monetary authorities change the money supply, the macroeconomic system adjusts to bring the demand for money in line with the supply of money. If the money supply is increased while the economy is in a recession, the extra money will probably flow into the stock and bond markets, stimulating business. As the economy expands, income grows, and the demand for money grows, catching up with the supply of money and restoring monetary equilibrium. If the money supply is increased while the economy is at full employment, the extra money will cause an increase in the demand for goods relative to supply. Prices will go up until the real (inflation adjusted) value of the money supply has fallen sufficiently to stop the inflation.

Monetary theory supplies the theoretical foundation for monetary policy, which has to do with the regulation of the money supply growth rate. Economists disagree as to whether the money supply growth rate should be speeded up and slowed down to meet the apparent needs of the economy, or whether the money supply growth rate should remain at a fixed amount, probably between 3 and 5 percent per year. Many contemporary economists argue that a fixed money supply growth rate is the best guard against inflation and economic instability.