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

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