Sunday, April 3, 2011

Quantity Theory of Money

There are three versions of the Quantity Theory of Money.

1. American Version or the Cash Transactions Version or Fisher's Version.
2. Cambridge Version or the Cash Balance Version.
3. Friedman's Version.

1. American Version: According to Irving Fisher and others, the value of money is determined by the quantity of money. The value of money depends on the demand for and supply of money. There is a demand for money because money functions as the medium of exchange. Hence the demand for money depends upon the amount of goods and services, which the people want to purchase.

Thus the demand for money depends upon the total transactions in the economy and the price level. This can be represented by PT, where P = price level and T = total transactions.

The supply of money depends on the

a) Quantity of money
b) Velocity of circulation of money

The quantity of money includes the cash money and the credit money. This can be represented as M and M1. The velocity of circulation of cash and credit money can be represented as V and V1. From this analysis we get the following equation.

PT = MV + M1V1
Therefore, P = MV + M1V1 / T
Mr. Fisher tried to explain his theory on the basis of the assumption of full employment. Under full employment, supply of goods and services remain constant. Hence total transactions (T) and velocity of circulation of money (V+V1) also remain constant. Hence price (P) directly depends on quantity of money (M+M1).

Criticism: The quantity Theory of Money has been criticized by many economists on the following grounds.

1. This is based on the assumption of full employment. In less than full employment situation, when the quantity of money increases, price may or may not rise. Under this circumstance, when the quantity of money increases, investment will also increase. This will increase the supply of goods. Thus when demand and supply increases to the same extent, price may or may not rise.

This can be shown in the following diagram.
In this diagram D is the demand curve and S is the supply curve. T is the equilibrium position. So OP is the equilibrium price. As demand and supply increases, the new demand curve is D1 and the new supply curve is S1. T1 is the new equilibrium position. The price does not change, and remains at OP. So we can conclude that the Quantity Theory of Money comes to its own only when there is full employment situation.

2. According to the theory it is the quantity of money that determines the price. But according to the critics, in many circumstances such as war, inflation etc. it is the price that determines the quantity of money. In other words, price is not always determined by the quantity of money.

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