Basics of Monetary Economics
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. According to the quantity theory of money, the money supply in an economy is proportional to the general price level of goods and services.
The Quantity Theory of money is one of the Western theories of Money. We are going to learn further on this topic. Also, we are going to learn about other monetary theories which will help us understand the concept effectively.
The Quantity Theory of Money Definition
In the money supply, the quantity theory of money is the theory where the variations in the price are related to the variations. ‘Neo-quantity theory’ or the ‘Fisherian theory’ is the most common version known to many. It suggests that between the changes in the money supply and the general price level there is a mechanical and a fixed proportional relationship. In general, the quantity theory of money is where the increase in the quantity of money tends to create inflation and vice-versa.
Who formulated the Quantity Theory of Money?
This theory was formulated by a Polish mathematician named Nicolaus Copernicus in the year 1517 but it was later popularized by the economists Milton Friedman and Anna Schwartz. They popularized the theory after publishing their book which was named “A Monetary History of the United States, 1867-1960” in the year 1963.
Supply and Demand of Money in the Economy as per Quantity Theory of Money
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 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.
It is the same forces that will influence the supply and demand of any commodity that will also influence the supply and the demand for money. An increase in the supply of money will decrease the marginal value of the money. In simple words, when the money supply will increase, the purchasing capacity of one unit of currency will decrease. To adjust this decrease in the money’s marginal value, the prices of the goods and the services will rise. This will eventually result in a higher inflation level.
The Classical Quantity Theory 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.
Fisher's Quantity Theory of Money
An American economist named Irving Fisher provided the version of the transaction of the quantity theory of money in his book ‘The Purchasing Power of Money’ in the year 1911. According to Fisher, as the quantity of money in circulation increases the other things remain unchanged. The price level also increases in direct proportion as well as the value of money decreases and vice-versa.
Fisher’s theory can be best explained with the help of a famous equation i.e., MV = PT or P = MV/T
The value of money or price level is also determined by the demand and the supply of money.
Supply of money consists of a quantity of money in existence (M). It is multiplied by the number of times this money changes hands which is the velocity of money (V). V is the transaction velocity of the money in Fisher’s equation. 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.
Friedman Quantity Theory of Money
Friedman says that “money does matter”. He also says that his quantity theory is the theory of demand for money and not a theory of output, income, or prices. He then distinguishes between the two types of demand for money. The first type includes the money demanded transaction purposes. But the second type includes the money is demanded because it is considered an asset. Friedman treats the demand for money exactly like the demand for durable consumer goods.
FAQs on Quantity Theory of Money: Meaning and Applications
1. What does the quantity theory of money say in simplest terms?
The quantity theory of money is a basic economic theory that explains how the supply of money in an economy relates to its overall price level. In simple terms, the theory states that if the amount of money in an economy increases, then the price levels will also rise, assuming that the number of goods and the velocity of money stay the same. This idea links money supply directly to inflation and purchasing power. The core belief is that too much money chasing the same amount of goods causes inflation. Therefore, controlling the money supply is crucial for price stability, making this theory significant in monetary policy discussions.
2. How to calculate the quantity of money?
Calculating the quantity of money, also known as the money supply, typically involves adding up all forms of money within an economy. Economists often use the measures M1 and M2 for this purpose.
- M1 includes the most liquid forms like cash, coins, and checking account deposits.
- M2 includes everything in M1 plus savings accounts, small time deposits, and near-money assets.
3. What are the three main theories of money?
Economists have proposed several major theories to explain how money functions and impacts the economy. The three main theories of money are:
- Quantity Theory of Money: Proposes that the amount of money in the economy determines the price level.
- Keynesian Theory: Emphasizes money’s role in influencing interest rates and total demand.
- Monetarist Theory: Focuses on controlling the money supply to manage inflation and economic growth.
4. Who developed the quantity theory of money?
The quantity theory of money has roots going back to classical economists, but it was mainly popularized by Irving Fisher in the early 20th century. Fisher formulated the famous equation of exchange, linking money supply to price levels and economic output. Earlier ideas came from economists like David Hume and John Stuart Mill, but Fisher gave the theory a mathematical foundation. Modern versions of the theory, such as monetarism, were later advanced by Milton Friedman. The quantity theory remains influential in discussions about inflation and monetary policy today.
5. What is the equation for the quantity theory of money?
The equation at the heart of the quantity theory of money is called the equation of exchange. It is written as MV = PQ, where M is money supply, V is the velocity of money, P is the price level, and Q is the real output or quantity of goods and services. This equation shows that if the money supply (M) increases while velocity (V) and output (Q) stay constant, the price level (P) must rise. This relationship forms the mathematical basis of how changes in money supply affect inflation rates in an economy.
6. How does the quantity theory of money explain inflation?
According to the quantity theory of money, inflation occurs when the supply of money in an economy grows faster than the production of goods and services. This extra money chases the same quantity of products, pushing prices higher. The theory relies on the assumption that the velocity of money and real output are stable in the short run. Thus, increasing the money supply directly leads to rising inflation. Policymakers use this concept to warn that excessive money creation can erode people’s purchasing power and destabilize the economy.
7. What are the main assumptions of the quantity theory of money?
The quantity theory of money is built on several strong assumptions that shape its predictions about money and prices.
- Constant Velocity: The rate at which money circulates (velocity) stays stable.
- Stable Real Output: The economy’s total output of goods and services does not change in the short run.
- Direct Relationship: Any change in money supply leads directly to changes in price levels.
8. What are the main criticisms of the quantity theory of money?
While influential, the quantity theory of money faces several criticisms, especially regarding its assumptions and real-world relevance.
- Velocity of money is not always constant and can fluctuate due to technological or institutional changes.
- The theory assumes a direct and immediate link between money supply and price levels, ignoring delays or complexities.
- It overlooks the role of interest rates and expectations, which can also influence inflation and output.
9. How does the velocity of money affect the quantity theory of money?
Velocity of money is a key concept in the quantity theory, representing how often money is exchanged for goods and services in a given period. If the velocity increases, more transactions happen with the same amount of money, leading to higher potential spending and possibly higher prices. The theory often assumes that velocity is stable, but in reality, it can rise or fall depending on consumer confidence, payment technologies, or interest rates. Changes in velocity can either amplify or reduce the impact of changes in money supply on inflation, making it a crucial factor for economists and policymakers.
10. What is the importance of the quantity theory of money in modern economics?
The quantity theory of money remains highly influential in modern economics, especially in shaping central bank policies and discussions of inflation. It highlights the risks of uncontrolled money creation and supports the use of monetary policy to manage the economy. Many central banks consider money supply and its growth rates to set targets for price stability. While the theory’s assumptions are debated, its basic message—that an excessive increase in money supply fuels inflation—guides policy decisions worldwide. It continues to serve as a fundamental concept for understanding the relationship between money and the economy.
11. How is the quantity theory of money used in monetary policy?
Monetary authorities and central banks use the quantity theory of money as a guide when making decisions about the money supply. By monitoring money supply growth, policymakers aim to control inflation and keep the economy stable. If inflation rises, central banks might reduce money creation or raise interest rates to slow spending. Conversely, to stimulate economic activity during a slowdown, they can increase money supply. The theory informs these policy responses by clarifying the connection between money supply, price levels, and aggregate demand, making it a crucial tool for managing economic cycles.
