[Commerce Class Notes] on Quantity Theory of Money Pdf for Exam

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.