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Quantity Theory of Money

There are two approaches to analyze the Quantity Theory of Money. These are Fisher’s Theory and Cash Balance Approach. In this article, we will look at both these approaches to understand the Quantity Theory of Money in detail.

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Quantity Theory of Money

Fisher’s theory explains the relationship between the money supply and price level. According to Fisher,

MV = PT

Where,

  • M – The total money supply
  • V – The velocity of circulation of money. This also means that the average number of times a unit of money exchanges hands during a specific period of time.
  • P is the price level or the average price of the Gross National Product (GNP) and
  • T is the Total National Output.

Through this equation, Fisher showed that the relationship between money supply and the price level is direct and proportional. Also,

$$\text{The rate of change in money supply} \frac {dM}{M} = \text{The rate of change in the price level}  \frac {dP}{P}$$

Quantity Theory of Money

                                                                                                                                            Source: Pixabay

Fisher based his theory on three assumptions:

The relationship between M and P is proportional only when there are no changes in the values of V and T. In other words when V and T are constant.

  1. ‘V’ or the velocity of circulation of money depends on the spending habits of people. Since the spending habits of people are more or less stable, V is constant.
  2. In a situation of full employment or when all available factors of production are fully employed, ‘T’ or the Gross National Product is constant. At less than full employment, more money will lead to more output and hence, ‘P’ stays constant.
  3. The demand for money exists for transaction purposes only. Also, people spend their entire income immediately for transactions.

Learn more about the Functions of Money and its Demand in detail here.

Criticisms of Fisher’s Theory

  1. The Fisher’s equation is an abstract and mathematical truism. Also, it does not explain the process through which, ‘M’ affects ‘P’.
  2. The assumption the people use up the entire ‘M’ to immediately buy ‘T’, is unreal. In real life, no one spends all the money the moment he earns it. Fisher fails to explain the precautionary and speculative uses of money.
  3. There is no full employment. Every country has a natural rate of employment.
  4. Even if there is full employment, a country can bring in factors from abroad (the ones that are not available within the economy) and rise the national output.
  5. Since the theory assumes that people use the money only for transactions, it is usually called the Cash Transaction Theory.

Quantity Theory of Money – Cash Balance Approach

The Cash Balance Approach states that it is not the total money, but that portion of the cash balance that people spend which influence the price levels. Most people hold a cash balance in their hands rather than spending the entire amount all at once. According to this approach,

M = PKT

Where,

  • M – The money supply
  • P – The price level
  • T – The total volume of transactions and
  • K is the demand for money that people want to hold as cash balance

Quantity Theory of Money – Keynes

Keynes reformulated the Quantity Theory of Money. According to him, money does not directly affect the price level. Also, a change in the quantity of money can lead to a change in the rate of interest.

Further, with a change in the rate of interest, the volume of investment can change. Also, this change in investment volume can lead to a change in income, output, and employment along with a change in the cost of production.

Finally, all these factors will lead to a change in the prices of goods and services. In simple words, the Keynesian version of the Quantity Theory integrates the monetary theory with the general theory of value.

Solved Question

Q1. Explain the Fisher’s equation and its assumptions.

Answer:

Fisher attempted to explain the relationship between money supply and price level through the following equation:

MV = PT … where M – total money supply, V – the velocity of circulation of money, P – the price level, and T – the total national output.

According to this equation, the price level and money supply have a direct and proportional relationship with each other. However, he made the following assumptions:

  1. Since the spending habits of people are stable, V is usually constant.
  2. T is constant in case of full employment. Also, in case of less than full employment, P does not rise.
  3. People spend their entire income on transactions immediately.

Q2. What is the Cash Balance Approach?

Answer:

According to the Cash Balance Approach, it is the portion of the cash balance that people spend which affect the price levels. Unlike Fisher’s Theory, the total money does not affect the price level. This approach believes that most people do not spend their entire money all at once, Instead, they hold a certain cash balance in their hands. The equation of the cash balance approach is:

M = PKT … where M is the money supply, P is the price level, T is the total volume of transactions and K is the demand for money that people want to hold as a cash balance.

Therefore, the movement of money depends on the people’s desirability of holding cash.

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