Quantity Theory of Money - Cambridge Version and Friedman's Version

Quantity Theory of Money - Cambridge Version: The economists of Cambridge University such as Mr. Robertson, Mr. Pigou, Mr. Marshall and Mr. Keynes introduced a new version of the quantity Theory of Money. According to this version the value of money is determined by the demand for and supply of money, as the price of a commodity is determined by the demand for and supply of that commodity.

The equilibrium price is determined when the demand is equal to the supply. So the value of money will be determined when the demand for money is equal to the supply of money. Demand for money can be represented as Md and the supply of money can be represented by Ms.

There is a demand for money because money functions as a store of value. People want money because they want to hold money. This is known as Liquidity Preference. Thus the aggregate demand for money will depend on

1. Total transactions, - T
2. Price level - P, and
3. The portion of the total income which people want to hold - K.

This can be represented by PTK.
Supply of money depends on the quantity of money. It remains constant at any point of time. This can be represented by M. Therefore PTK = M.

From the above analysis we get the following equation.

Md = Ms.
That is, PTK = M
Or, P = M / TK. That means price level is equal to quantity of money divided by total transactions times portion of total income that people want to hold.

Comparison between American Version and Cambridge Version

If we make a comparison between the two versions of the Quantity Theory of Money, we find out that there are some points of similarity and distinction between the two.

Distinction: The following are the points of distinction between the two versions.

1. In the American Version they have emphasized on the function of money as the medium of exchange. But in the Cambridge Version they have emphasized money as a store of value.
2. In the American Version they have emphasized on the velocity of circulation of money; in other words on the movement of money. But in Cambridge Version they have emphasized upon the desire of people to hold money.
3. In the American Version the value of money is determined in a given period of time. In the Cambridge Version the value of money is determined at a point of time.

Similarity: If we analyze the American and Cambridge Versions of the Quantity Theory of Money, we can point out the following similarities between the two.

1. Both these versions more or less use the same symbols to explain the theory.
2. Both these versions tried to determine the value of money. According to these versions the value of money is determined by the quantity of money.

Conclusion: Of the Two Versions of the Quantity Theory of Money, the Cambridge Version is regarded as superior to the American version, because it is based on the General Theory of Value, which is accepted by all modern economists. However, from the academic point of view, none of the versions can be ignored.
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Quantity Theory of Money - Friedman's Version: In 1936 Mr. Keynes published his book, The General Theory of Employment, Interest and Money. After the publication of this book, the Quantity Theory of Money lost its popularity. In 1960, Milton Friedman of Chicago University tried to revive the importance of The Quantity Theory of Money. So he introduced a new version of the Quantity Theory of Money.

According to him there is a demand for money because men want to hold wealth. Hence the equation is

P = M / Dm

Where P is the price level,

M is the Quantity of money, and

Dm is the demand for money for wealth.

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.