Quantity Theory of Money

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Quantity theory of Money

QTM is the crux of the classical monetary thoughts which proclaims the idea of a unique functional relationship between money and prices. The classical author J.S.Mill, “ the value of money, other things be the same, varies inversely as its quantity; every increase of quantity lowers the value and every diminution raising it in a ratio exactly equal” .

The QTM implies that the quantity of money brings about a directly proportionate change in the price level and hence an inversely proportionate change in the value of money. There are 2 refined approaches to the traditional quantity theory of money : 1) Transactions approach 2) Cash balance approach

1) Transactions Approach (Fisher’s version) – Prof. Irving Fisher present the QTM by giving it a commodious pedagogical shape in terms of equation of exchange. In a money economy, a transaction encompasses purchase and sale of goods through money as a medium of exchange. Thus, in the economy as a whole, over a period of time, total money value purchases equals to the total money value of sale. All goods and services are sold during a given period of time (Total transactions T), and their prices together as P, PT represents total money value of sales.

Fisher put fords the following identity, MV = PT, which is often described as the equation of exchange.

MV = PT

P = MV/T which implies that quantity of money (M) determines the price level (P), the latter varies directly proportion to the change in the stock of money assuming (T) and (V) to be constant

In this equation of exchange, however , only primary money or currency money is conceived . But in the modern economy, money includes Demand deposits of Banks or Credit money also. Thus the extended form of the equation of exchange

P = (MV + M’ V’) /T

M – The quantity of money in circulation

V – Velocity of circulation of money

M’ – The quantity of bank money in circulation

V’ – Velocity of circulation of bank money

The equation further denotes that the price level (P) is directly related to M,V,M’,V’.

Assumptions

1. The price level, P is a passive element. This means P does not change by itself.

2. The total volume of transaction T is an independent element in the equation. The factor T can be regarded as constant over short periods of time .

3. The velocity of circulation of money V is an independent element in the equation and is constant over short period of time.

4. The magnitude of Bank money M’ depends on commercial bank’s credit creation activity, which in effect is a function of the currency money M.

In brief the Firsherian version emphasizes that the quantity of money and changes in it are the only significant casual factor that affects the value of money. Further the equation MV = PT also interpreted in another since where M may be regarded as the economy’s demand for money. Thus M= PT/V, M denots demand for money, varies directly and proportionally with the price level P when annual transactions T and the spending rate of community V are unchanged.

Criticism

1. The equation of exchange by itself provides no analytical clue to the determinants of value of money.

2. The price level, P, is not a passive as assumed by Fisher. P does influence T because rising prices give profit incentives to business expansion, T would increase.

3. Fisher regards V as independent constant but in practice V may vary with the volume of trade and price level.

4. Fisher’s explanation is mechanical because the theory gives an impression that the price level can be controlled by regulating the variables mentioned in the equation .

5. This approach is one sided. It considers the supply of money as the most effective.

6. Keynes observed that the equation MV = PT artificially divorces the theory of money from the general theory of...
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