Quantity Theory of Money

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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 supplied in an economy is proportional to the general price level of goods and services.

This theory was actually 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.

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 increases, 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 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.

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 the 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 of time.

Therefore, MV refers to the total volume of the money in circulation during a period of time. 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 of time.

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.

FAQ (Frequently Asked Questions)

1. What is Friedman Demand Function?

Ans: The supply of money is independent of the demand for money in Friedman’s modern quantity theory of money. Because of the actions of monetary authorities, the supply of money changes. Here the demand for money remains almost stable. That means the amount of money that people want to have as cash or bank deposits is almost fixed to their permanent income.

Now, if the central bank purchases securities then the people who will sell the securities to the central bank will receive money. This will lead to an increase in their cash holdings. The excess money will be spent on consumer goods as well as partly by purchasing assets. This spending will eventually reduce their cash balances and there is also a rise in the national income.

When the central banks sell securities the money holding of the people also decreases in the relation to their permanent income. This will lead to reducing consumption which will reduce national income. Therefore in both cases, the demand for money remains stable. 

2. Write about the Keynesian Quantity Theory of Money and the Cambridge Quantity Theory of Money.

Ans: According to Keyne, money does not affect the price level. 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.

All these factors will lead to a change in the prices of goods and services. Basically,  Keyne’s theory integrates the monetary theory with the general theory of value.

According to Cambridge Economists, the amount of the money which is kept by the individual, commercial institutions as well as by the government to meet their daily needs is called the demand for money.