So, the total output or supply of goods cannot increase. Therefore, the total volume of transactions and trade will remain same. This theory states that, the price level rises proportionality with a given increase in the quantity of money, other things remaining the same and vice versa. According to Alfred Marshall, the value of money depends on the demand and supply of cash balances for a given period of time. It may be noted that the above Fisher’s Equation include only primary money or currency money. But modern economy extensively uses demand deposits or credit money.
Because of the actions of monetary authorities, the supply of money changes. That means the amount of money that people want to have as cash or bank deposits is almost fixed to their permanent income. In the money supply, the quantity theory of money is the theory where the variations in the price are related to the variations.
The Quantity Theory of Money Definition
According to Marshall, people’s desire to hold money is more powerful in the determination of money, rather than quantity of money . So, peoples’ desire to hold money is a determinant of the value of money. The principle of the classical theory is that the economy is self-regulating. The economy is always the potential of achieving the natural level of real GDP or output. This is the level of real GDP which is obtained when the economy’s resources are fully employed.
Money is demanded not for its own sake (i., for hoarding it), but for transaction purposes. The demand for money is equal to the total market value of all goods and services transacted. It is obtained by multiplying total amount of things by average price level . The quantity of money in the economy consists of not only the notes and currency issued by the government or central bank but also the amount of credit or deposits created by the banks. But the classical and neo classical economists believed that there is full employment of all resources in the economy.
The greater the supply of goods and services in the economy, the larger the number of transactions and trade and vice versa. It was first propounded in 1588 by an Italian economist, Davanzatti. He gave it a quantitative form in terms of his famous “Equation of Exchange”. All these factors will lead to a change in the prices of goods and services. Keyne’s theory integrates the monetary theory with the general theory of value.
Demand for money or the total value of all items transacted. The value of money is inversely proportional to the price level or we can say that the value of money is the reciprocal of the price level. Value of money means its purchasing power in terms of goods and services in general. If the prices are high, the value of money will be low. Conversely, if the prices are low, money will buy more and the value of money will be high.
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It was on account of the growing importance of credit money that Fisher later on extended his equation of exchange to include credit money. According to them, the theory fails in the short run when the prices are sticky. Moreover, it has been proved that velocity of money doesn’t remain constant over time. Despite all this, the theory is very well respected and is heavily used to control inflation in the market. Fisher expressed the relation between the quantity of money and the price level in the form of an equation, which is called the equation of exchange. Now, if the central bank purchases securities, then the people who will sell the securities to the central bank will receive money.
This equation implies that the price level varies inversely with k or R and directly with M. The equation states the fact that the actual total value of all money expenditures always equals the actual total value of all items sold . There are various factors which determine the value of money and the general price level.
Since money is only to be used for transaction purposes, total supply of money also forms the total value of money expenditures in all transactions in the economy during a period of time. Irving Fisher used the equation of exchange to develop the classical quantity theory of money, i., a causal relationship between the money supply and the price level. Monetary economics is the branch of economics that studies the different theories of money. The quantity theory of money is the primary research area for this branch of economics.
FAQs on Quantity Theory of Money
Superiority of Cash Balance Approach over Transactions Approach The Cash Balance approach to the Quantity Theory of Money is superior to the Transaction Approach on the following grounds. The Transaction approach emphasizes the medium of exchange function of money only. On the other hand, the Cash Balance approach stresses equally the store of value function of money. Therefore, this approach is consistent with the broader definition of money which includes demand deposits. In its explanation of the determinants of V, the Transaction approach stresses the mechanical aspects of the payments process.
He says a change in the quantity of money can lead to a change in the interest rate. The volume of investment can be changed with the change in the interest rate. This can lead to a change in income, output, cost of production, and employment. An increase fishers quantity theory of money in the total supply of money will increase the general price level. The theory states that the price level is directly determined by the supply of money. It is assumed that the demand for money is proportional to the value of transactions.
- The principle of the classical theory is that the economy is self-regulating.
- V is the transaction velocity of the money in Fisher’s equation.
- But the classical and neo classical economists believed that there is full employment of all resources in the economy.
It is based on the assumption of the existence of full employment in the economy. Quantity supplied is the quantity of a commodity that producers are willing to sell at a particular price at a particular point of time.
The assumption and criticism of Fisher’s quantity theory of money. In the Cash Balance approach k was more significant than M for explaining changes in the purchasing power of money. This means that the value of money depends upon the demand of the people to hold money. This equation shows that the purchasing power of money or the value of money varies directly with k or R, and inversely with M.
According to the quantity theory of money, if the amount of money in the economy gets doubled up then the price level also doubles. It means that the customers will have to pay twice as much for the same amount of goods https://1investing.in/ and services. This drastic increase in the price levels will result in a rising inflation level. A measure of the rate of the rising prices of goods as well as of the services in an economy is known as inflation.
The price level also increases in direct proportion as well as the value of money decreases and vice-versa. The supply of money consists of the quantity of money in existence multiplied by the number of times this money changes hands, i., the velocity of money . The supply of money is independent of the demand for money in Friedman’s modern quantity theory of money.
Basics of Monetary Economics
In contrast, the Cash Balance approach is more realistic as it is behavioral in nature which is built around the demand function for money. As to the analytical technique, the Cash Balance approach fits in easily with the general demand-supply analysis as applied to the money market. This feature is not available in the Transaction approach. The Cash Balance approach is wider and more comprehensive as it takes into account the income level as an important determinant of the price level.
Quantity Theory of Money – Fisher’s Transactions Approach
That means that the average number of times a unit of money turns over or changes hands to effectuate transactions during a period. Therefore, MV refers to the total volume of the money in circulation during a period. Since the money is only to be used for transaction purposes; the total supply of money also forms the total value of money expenditure in all the transactions in an economy during a period.