Quantity Theory of Money free essay sample

Quantity theory of Money QTM is the crux of the classical monetary thoughts which proclaims the idea of a unique functional relationship between money and prices. The classical author J. S. Mill, â€Å" the value of money, other things be the same, varies inversely as its quantity; every increase of quantity lowers the value and every diminution raising it in a ratio exactly equal† . The QTM implies that the quantity of money brings about a directly proportionate change in the price level and hence an inversely proportionate change in the value of money. There are 2 refined approaches to the traditional quantity theory of money : 1) Transactions approach 2) Cash balance approach 1) Transactions Approach (Fisher’s version) – Prof. Irving Fisher present the QTM by giving it a commodious pedagogical shape in terms of equation of exchange. In a money economy, a transaction encompasses purchase and sale of goods through money as a medium of exchange. Thus, in the economy as a whole, over a period of time, total money value purchases equals to the total money value of sale. All goods and services are sold during a given period of time (Total transactions T), and their prices together as P, PT represents total money value of sales. Fisher put fords the following identity, MV = PT, which is often described as the equation of exchange. MV = PT P = MV/T which implies that quantity of money (M) determines the price level (P), the latter varies directly proportion to the change in the stock of money assuming (T) and (V) to be constant In this equation of exchange, however , only primary money or currency money is conceived . But in the modern economy, money includes Demand deposits of Banks or Credit money also. Thus the extended form of the equation of exchange P = (MV + M’ V’) /T M – The quantity of money in circulation V – Velocity of circulation of money M’ – The quantity of bank money in circulation V’ – Velocity of circulation of bank money The equation further denotes that the price level (P) is directly related to M,V,M’,V’. Assumptions 1. The price level, P is a passive element. This means P does not change by itself. 2. The total volume of transaction T is an independent element in the equation. The factor T can be regarded as constant over short periods of time . 3. The velocity of circulation of money V is an independent element in the equation and is constant over short period of time. 4. The magnitude of Bank money M’ depends on commercial bank’s credit creation activity, which in effect is a function of the currency money M. In brief the Firsherian version emphasizes that the quantity of money and changes in it are the only significant casual factor that affects the value of money. Further the equation MV = PT also interpreted in another since where M may be regarded as the economy’s demand for money. Thus M= PT/V, M denots demand for money, varies directly and proportionally with the price level P when annual transactions T and the spending rate of community V are unchanged. Criticism 1. The equation of exchange by itself provides no analytical clue to the determinants of value of money. 2. The price level, P, is not a passive as assumed by Fisher. P does influence T because rising prices give profit incentives to business expansion, T would increase. . Fisher regards V as independent constant but in practice V may vary with the volume of trade and price level. 4. Fisher’s explanation is mechanical because the theory gives an impression that the price level can be controlled by regulating the variables mentioned in the equation . 5. This approach is one sided. It considers the supply of money as the most effective. 6. Keynes observed that the equ ation MV = PT artificially divorces the theory of money from the general theory of value. . ) Cash –Balance Approach_ This approach propounded by the Cambridge economists, Marshal, Pigou, Robertson and Keynes. According to CB approach, Value of money depends upon the supply of and demand for money. The value of money is at any time is fixed at the level at which it supplies equated to demand and the variations in its value through time arise out of the changes in its supply or its demand or both. This concept follows that the people in a community fix the amount of purchasing power that they wish to hold in the form of money. They thereby determine the aggregate purchasing power of oney supply. Since the demand for money determines the aggregate purchasing power of money supply, it follows that, with a given demand, the purchasing power of each unit of money varies inversely and the price level directly, with the quantity of money The relation between supply of and demand for money so conceived is exposed by the advocates of cash balance approach by formulating equations (Cambridge equation) Marshal , Pigou, Robertson and Keynes are the four noted authors of Cambridge each of them has framed his own type of cash balance equation. Marshallian Equation M = K PY M = Quantity of money (Currency + Demand deposit) P = Price Y = Aggregate real income K = fraction of real income people ready to hold Pigou’s Equation P = KR/M. P = Purchasing power of money (value of money). R = Total real income expressed in terms of any commodity say wheat or rice. K = Proportion of real income (R) held by people in the form of legal tender. M = no of units of legal tender(or total money stock. ie. cash) Robertson’s Equation P = M/KT P = Price level T = Total amount of goods and services to be purchased during a year (annual transaction) K = Fractional part of T over which people wish to hold command in the form of cash Keynes Real Balance Equation P = N/K P = Price of a consumption unit N = Quantity of money in circulation K = Real balance. It is measured as the amount of consumption units the community refers to hold in the form of cash. To consider the bank deposits component of money supply Keynes extended the equation as P = n/(K+rk’) where r denotes cash reserve ratio K stands for real balance held in the form of bank money. Thus if K, k’ and r remain unchanged, n and P will vary in the same proportions. Short comings of Cash-Balance approach 1. Pigou and Keynes deal with the purchasing power of money in terms of consumption of goods only (Narrow view). 2. Cash balance approach considered only one factor ie. The real income as the determinant of K. 3. This approach also assumes K and T as given like in the transactions approach. 4. Cambridge version gives an incomplete picture of the forces and processes by which changes in the price level take place.