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.

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Quantity Theory of Money – Transaction Approach

                                                                                                                                                   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).

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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.