Quantity Theory of Money

Theory of Irving Fisher

  • As the quantity of money in an economy increases, the price (inflation) tends to rise.
  • Value of money started to fall
  • There is direct relationship between Money supply and Price
  • There is indirect relationship between Money supply and Value of money

Assumptions of the theory

  1. Velocity remains constant
  2. Volume of transactions remains constant
  3. Economy is at full employment
  4. Price is a passive factor
  5. This is a long run theory
  6. Money used only as a medium of exchange
TipEquation

MV = PT

Where,
M = Money Supply
V = Velocity of Money
P = Average Price Level
T = Volume of transactions

Supply side (MV)

This shows total money supply in an economy

Demand Side (PT)

This shows total money demanded for transaction purpose

As per assumption V and T are constant;

So, M=P, meaning price level increases when there is increase in money supply

Criticisms

  1. V and T cannot be constant
  2. Full employment is not constant
  3. Interest rate is neglected
  4. Applicable only in the long run
  5. Too much emphasis on money supply
  6. Money is not only used as a medium of exchange

Cambridge Approach

  • Cambridge Economists like Pigou and Marshall (1917)
  • Value of money is determined by demand and supply of money
  • Store of value as a function of money
  • Hold nominal income i.e., Cash Balance (k)
    Md = kPy
    Where,
    Md = Money demanded
    k = Portion of nominal income
    P = Price Level
    y = Real National Income
    py = Nominal National Income

Money supply (M) is exogenous in the economy.

At equilibrium,
Md = M

TipCambridge Equation

Md = kPy

k is holding that we are keeping with ourselves. As k increases velocity of circulation will decrease \(k=\frac{1}{v}\)

\[M = \frac{1}{v}Py\] \[P=\frac{1}{k}.\frac{M}{y}\] As per the assumption,
k and y are constant, So, Price Level depends on Money supply

Criticisms

  1. k and y cannot be constant
  2. Neglects interest rate
  3. Neglects speculative Demand for money
  4. Price level doesn’t measure purchasing power
  5. Too much emphasis on money supply
  6. Neglects Savings and Investment