QUANTITY THEORY OF MONEY

QUANTITY THEORY OF MONEY

Quantity theory of money explains the relationship between quantity of money and general price level . According to it there is a direct and proportionate relationship between quantity of money as well as general price level. Basic equation of quantity theory of money is given by equation of exchange formulated by fisher in its transaction form. It is expressed as-

                                                MV=PT,

where M is the quantity of money . V is the transaction velocity of money. It is defined as no. of times  a unit of money is used in making transactions involving currently produced goods as well as previously produced goods. P is the price index of transactions. V is the volume of transactions.

  • Same equation can be expressed in income form as MV=PY. V is the income velocity of money.
  • In classical approach output of economy is constant due to full employment of resources. In addition, velocity is assumed to be constant because it is determined by institutional factors . FOR EXAMPLE- banking habits, facilities of credit cards, ATM etc . These institutional factors do not change in short run. Therefore, if the output is constant as well as velocity is constant . There is a direct and proportionate relation between quantity of money and price level.
  • Note-
  • FOR EXAMPLE-

V=PT/M

=(RS.30/year)/(RS.10)

= 3 times per year

Percentage change in M + percentage change in V = percentage change in P + percentage change in Y.

FOR EXAMPLE-

10 % + 0 = INFLATION RATE + 0

 

source – google images

  • CASH BALANCE FORMULATION-

It is expressed by Cambridge equation

M= K(PY)

Where k is he Cambridge constant and it is the inverse of velocity of money. According to this approach , money demand is assumed to be a fraction which is determined by Cambridge constant.

The main difference between velocity formulation and cash balance formulation is that in velocity formulation, focus is on how rapidly money is spent. In cash balance formulation, we determine how much income is not spent as well as it is kept in cash balance.

 

CONCLUSION-  The quantity theory of money is an identity.  If one variable changes . Therefore one or more variable must also change. This will maintain the equality. For example- if M rises and V remains constant then either P or T must rise.

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