In view of the coronavirus pandemic, we are making LIVE CLASSES and VIDEO CLASSES completely FREE to prevent interruption in studies
Home > Business Economics - CS > Money and Banking > Quantity Theory of Money
Money and Banking

Quantity Theory of Money

The Quantity Theory of Money seeks to explain the factors that determine the general price level in an economy. According to this theory, the supply of money directly determines the price level. In this article, we will look at the Transaction Approach and the Cash Balance Approach of the Quantity Theory of Money.

Suggested Videos

Play
Play
Play
Arrow
Arrow
ArrowArrow
Introduction to Economics
Nature of Economics
Utility of Economics to Society
Slider

Quantity Theory of Money – Transaction Approach

quantity theory of money

                                                                                                                                                   Source: Pixabay

Fisher’s gave the Transaction Approach to the Quantity Theory of Money. The following equation of exchange explains it:

MV = PT

Where,

  • M – The total supply of money
  • V – The velocity of the circulation of money
  • P – The general price level
  • T – The total transactions in physical goods

In simple words, this equation means that in an economy, the total value of all goods sold during any period (PT) is equal to the total quantity of money spent during that period(MV).

Browse more Topics under Money And Banking

Assumptions

  • The price level is measured over a period of time
  • There are no credit sales in the market
  • Money is only a medium of exchange
  • Each unit of money can change hands several times during the said time interval.
  • All cash payments received during the year are equal to the volume of goods and services sold multiplied their respective prices.

The Transaction Approach

Based on these assumptions, the equation of exchange becomes the Quantity Theory of Money. This also shows that there is an exact, proportional relationship between the price level and the supply of money.

In other words, the price levels are directly proportional to the quantity of money in circulation in the economy. So, if the supply of money is doubled, then the price of money would double too.

This is based on the idea that the demand and supply of money determine the price levels. Fisher also extended the equation to include demand deposits (M’) and their velocity (V’) in the total supply of money. Therefore, the equation becomes:

MV + M’V’ = PT

Or,

P = \( \frac {MV + M’V’}{T} \)

Where,

  • M = Currency
  • M’ = Bank’s money
  • V & V’ = Respective velocities

Therefore, the general price levels depend on all five variables of the equation.

Quantity Theory of Money – Cash Balance Approach

The Cash Balance Approach to the Quantity Theory of Money is expressed as:

π = kR/M

Where,

  • π is the purchasing power of money
  • k is the proportion of income that people like to hold in the form of money
  • R is the volume of real income
  • M is the stock of supply of money in the country at a given time

This equation shows that the purchasing power of money or the value of money (π) varies directly with k or R. Also, it is inversely proportional with M. Further, since π is the reciprocal of the general price level,

π = \( \frac {1}{P} \)

⇒ \( \frac {1}{P} \) = \( \frac {kR}{M} \)

⇒ M = kRP

If we multiply the volume of real income (R) with the general price level (P), then we get the national money income (Y).

M = kY

Further, in the Cash Balance Approach, k is more significant than M in order to explain the changes in the purchasing power of money. This means that the value of money depends upon the demand of the people to hold money.

Solved Question

Q1. What is the Quantity Theory of Money?

Answer:

The Quantity Theory of Money seeks to explain the factors that determine the general price level in an economy. According to this theory, the supply of money directly determines the price level.

Share with friends

Customize your course in 30 seconds

Which class are you in?
5th
6th
7th
8th
9th
10th
11th
12th
Get ready for all-new Live Classes!
Now learn Live with India's best teachers. Join courses with the best schedule and enjoy fun and interactive classes.
tutor
tutor
Ashhar Firdausi
IIT Roorkee
Biology
tutor
tutor
Dr. Nazma Shaik
VTU
Chemistry
tutor
tutor
Gaurav Tiwari
APJAKTU
Physics
Get Started

3
Leave a Reply

avatar
3 Comment threads
0 Thread replies
1 Followers
 
Most reacted comment
Hottest comment thread
3 Comment authors
GlorysamSedex sabuvivek kumar Recent comment authors
  Subscribe  
newest oldest most voted
Notify of
vivek kumar
Guest
vivek kumar

what are 5 websites of internet banking and e baking ?

Sedex sabu
Guest
Sedex sabu

Does e-banking stop inflation?

Tere baap
Guest
Tere baap

Fuck u

Ali
Guest
Ali

Beta aukat

Stuck with a

Question Mark?

Have a doubt at 3 am? Our experts are available 24x7. Connect with a tutor instantly and get your concepts cleared in less than 3 steps.
toppr Code

chance to win a

study tour
to ISRO

Download the App

Watch lectures, practise questions and take tests on the go.

Get Question Papers of Last 10 Years

Which class are you in?
No thanks.