Class XI, Principles of Economics, "Quantity Theory of Money"

Quantity Theory of Money

Theory

The quantity of money states that other things remaining the same, the value of money falls in proportion to increase in the quantity of money in circulation. It mans that in the case, when the quantity of money increases by 25%, the value of money falls by 25%. Thus the quantity of money and its value of money are inversely related.

Explanation
The value of money like any other commodity is determined by its demand and supply. Thus the quantity theory of money can be explained under these two heads.

1. As Regards Demand of Money

Demand of money according to Fisher is the derived demand i.e. not for direct consumption. Money being a medium of exchange is demanded for the purchasing of goods and services. Demand for money therefore depends upon the demand for goods and services.

2. As Regards Supply of Money

According to Fisher supply of money is represented by the total expenditure made by the people calculated during a given period of time. The total expenditure made by the people is calculated by multiplying the total quantity of legal tender money by its velocity plus the bank money (cheque, drafts etc) multiplied by its velocity. Velocity of money means the number of hands that one unit of money changes during a given period of time. For example a RS 100 note changes 10 hands in a year, its velocity will therefore be 10. It means that total payment made by this note will be .

RS. 100 * 10 = RS. 1000

According to Fisher, supply of money is determined by the following equation.

MV + M‘V’

M represents the actual money and M’ the bank money where as V and V’ represent their respective velocities.

Demand for money is represented by price multiplied by turnover i.e. total quantity of goods and services sold and therefore demand is determined as:

Demand of money = P x T

Where P is the price and T is the turnover.

Since the value of money is determined at a point where its demand is equal to supply and accordingly Fisher gives the following equation of exchange:

PT = M‘V’ + MV
Or
P = (M‘V’ + MV)/T

According to the above definition / equation, the price level is determined by dividing the total supply of money by turnover.

Criticism

The quantity theory of money is theoretically convincing but practically it is consider as a misleading one.

1. The very assumption in the theory that other things remaining same are incorrect. Fisher assumed money as independent variable where as credit (M’) is a function of business activity i.e. the turnover. It means the turnover increases, the supply of bank or credit also increases and consequently money is not an independent variable.

2. Velocity of money and bank money has been assumed is assumed in this theory to be constant where as they are not so because they depend upon business activity which is never constant.

3. The theory fails to explain as to why during depression the increase in supply of money does not bring a corresponding increase in the price level.

4. According to quantity theory high price is the effect of increase in supply of money which is not always true. Scarcity of goods caused by a fall in production or increase in production with respect to an increase in population also raises the price level.

5. It is argued that Fisher’s equation is only valid in a static economy. The economy becomes static beyond full employment level because the physical production does not increase in such a situation. the extra money if introduced in such a stage of economy is not absorbed by increased quantity of output and consequently the price level is directly affected. This shows that Fisher equation in a dynamic economy is of no use.