Quantity Theory of Money

By: VIKRAM.G.BFaculty, P.G dept. of Commerce

Bangalore-55

Value of money refers to the purchasing power of money over goods and services in a country.

A relative concept which explains the relationship between a unit of money and goods and services which can be purchased with it.

What is meant by Value of money?

Types of Value of money :Internal and External Value of money

Internal value of money: It refers to the purchasing power of money over domestic goods and services.

External value of money: It refers to the purchasing power of money over foreign goods and services.

The concept of the quantity theory of money (QTM) began in the 16th century. As gold and silver inflows from the Americas into Europe were being minted into coins, there was a resulting rise in inflation.

The idea is that, the money supply will directly impact both prices and inflation rates.

The quantity theory of money states that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services sold. 

According to QTM, if the amount of money in an economy doubles, price levels also double, causing inflation (the percentage rate at which the level of prices is rising in an economy). The consumer therefore pays twice as much for the same amount of the good or service.

Quantity Theory of Money:

Another way to understand this theory is to recognize that money is like any other commodity: increases in its supply decrease marginal value (the buying capacity of one unit of currency). So an increase in money supply causes prices to rise (inflation) as they compensate for the decrease in money’s marginal value.Money market Shift in the Money market

Irving Fisher an American economist, put forward the Cash Transaction Approach to the quantity theory of money. He in his book The Purchasing Power of Money (1911) has stated that the value of money in a given period of time depends upon the quantity of money in circulation in the economy

“Other things remaining unchanged, as the quantity of money in circulation increases, the price level also increases in direct proportion and the value of money decreases and vice versa”.

If the quantity of money is doubled, the price level will also double and the value of money will be one half. If the quantity of money is reduced by one half, the price level will also be reduced by one half and the value of money will be twice.

Fisher’s Quantity Theory of Money: The Cash Transaction Approach

In Fisher’s Cash Transactions Version of Money, the general price level in a country, like the prices of commodities, is determined by the supply of and demand for money.

Supply of Money: The supply of money consists of the quantity of money in circulation (M) and the velocity of its circulation (V) i.e., the number of times the money changes hands. Thus MV refers to the total volume of money in circulation during a period of time. For example, if the total money supply in India Rs. 5,000 billion and its velocity per unit of time is 10 times, then the total money supply would be Rs. 5,000 x 10 = Rs.50000 billion.

Demand for Money: People demand money not for its own sake. They demand money because it serves a medium of exchange. It is used to carry every day transactions. In short, the demand for money is for the exchange of goods.

Equation of Exchange: The Cash transaction version of the quantity theory of money was presented by lrving fisher in the form of an equation:P = MV + M1 V1   or PT= MV+ M1V1                 THere,P is the price LevelM is the quantity of moneyV is the velocity of circulation of MM1 is the volume of credit moneyV1 is the velocity of circulation of M1T is the total volume of goods and Trade

Let us suppose M = Rs. 2000, M1 is Rs = 1000, V = 6, V1 = 4 and T = 8000 goods.

In figure 4.1 (a) it is shown that when the supply of money is increased from QM to QM2, the price level also rises from OP1 to OP2. As the quality of money increase four times to QM4, the price level also increases four times to OP4.

In figure 4.1(b) the inverse relationship between quantities of money in circulation and the value of money is shown. When the quantity of money is QM1, the value of money is VM1. When the money supply is doubled from QM1 to QM2, the value of money is reduced to half from VM1 to VM2.

Full employment: The theory is based on the assumption of full employment in the economy.

T and V are constant: The theory assumes that volume of trade (T) in the short run remains constant.  So is the case with velocity of money (V) which remains unaffected.

Constant relation between M and M1. Fisher assumes constant relation between currency money M and credit money (M1).

Price level (P) is a passive factor. The price level (P) is inactive or passive in the equation. P is affected by other factors in equation i.e., T, M, M1, V and V1 but it does not affect them.

It is assumed that the demand for money is proportional to the value of transaction.

The theory is applicable in the long run.

Assumptions of the theory:

Unrealistic assumptions: The theory is based on unrealistic assumptions. In this theory P is considered as a passive factor. T is independent. M1, V, V1, are constant in the short run. All these assumptions are covered under “Other things remaining the same.” In actual working of the economy, these do not remain constant; Hence, the theory is unrealized and misleading.

Various Variables in the transaction are not independent.  As assumed in the theory The fact is that they very much influence each other For example when money supply (M) increases the velocity f money (V) also goes up Take an other case. Fisher assumes (P) is a passive factor and has no effect on trade (T). In actual practice, when price level P) rises, it increases profitts and promotes trade (T).

Criticisms of the theory:

Assumption of full employment is wrong. J. M. Keynes has raised en objection that the assumption of full employment is a rare phenomenon in the economy and the theory is not real.

Rate of interest ignored. In the quantity theory of Fishers, the influence of the rate of interest on the money supply and the level of prices have been completely ignored. The fact is that an increase or decrease in money supply has an important bearing on the rate of interest. An increase in money supply leads to a decline in the rate of interest and vice versa.

Fails to explain trade cycles. The theory fails to explain the trade cycles. It does not tell as to why during depression, the increase in money supply has little impact on the price level, Similarly, in boom period the reduction in money supply or tight money policy may not bring down the price level G. Crowther is right in saying, “The quantity theory is at best an imperfect guide to the cause of the business cycle”.

Ignores other factors of price level. There are many determinants other than M, V, and T which have important implication on the price level. These factors such as income, expenditure, saving, investment, population consumption etc have been ignored from the

purview of the theory. Weak Theory: According to Crowther, QTM is weak in

many respects. i. It cannot explain ‘why’ there is a fluctuations in the

price level ii. It gives undue importance to the price level. iii. Misleading emphasis on the quantity of money as the

principal cause of changes in the price level during the trade cycle.

Friedman avows that the quantity theory is fundamentally a theory of the demand for money. It is not a theory of output, or of money income, or of the price level.

Friedman regards the amount of real cash balances as a commodity which is demanded because it yields services to the person who holds it. Thus money is an asset or capital good, hence demand for money forms part of capital or wealth theory.

Acc.to Friedman total wealth includes all sources of income or consumable services which is capitalized income.

wealth can be held in 5 different forms:i. Moneyii. Bondsiii. Equitiesiv. Physical goodsv. Human capital

Friedman’s restatement of QTM

The present discounted value of expected income flows can be expressed as:

W=y/r Where W is the current value of total wealth, y is the

total flow of expected income from the five forms of wealth and r is interest rate.

Friedman expands the detail of wealth and returns to indentify the variety of assets and returns in the potential portfolio:

where P is the price level, rb is the return on bonds, re is the return on equities, ra is the return on real assets, w is the ratio of human to nonhuman wealth (to capture the return on “human wealth”), /r is total wealth, and u is the “portmanteau variable.”

urwrrrPfM aeb ;,,,,,

In the theory of QTM by Friedman, the supply of money is independent of the demand for money. The supply of money is unstable due to the actions of monetary authorities. On the other hand, the demand for money is stable.

Thus, Friedman presents the quantity theory as the theory of the demand for money and the demand for money is assumed to depend on asset prices or relative returns and wealth or income. He shows how a theory of the stable demand for money becomes a theory of prices and output. A discrepancy between the nominal quantity of money demanded and the nominal quantity of money supplied will be evident primarily in attempted spending.

Very broad definition of money Money not a luxury good More importance to wealth variables Money supply not exogenous Ignores the effect of other variables on

money supply Does not consider time factor

Criticisms: