Quantity Theory

Quantity Theory

Quantity Theory of Money, asserts that the general price level depends on the amount of money in circulation. It is usually formulated in terms of the equation': MV = PT, where M is the quantity of money (including bank deposits) and V is the velocity of circulation of money, i.e. the average number of times which a unit of money is spent during a defined period for a quantity of goods and services T whose average price is P.

The equation states that the total quantity of money spent in a period (MV) is equal to the volume of transactions multiplied by the price of each transaction. It is therefore essentially a truism, and does not show a causal connection between the components ('variables') in the equation. For the quantity theory to bold good further assumptions about the behaviour of V and T must be true. It does, however, serve as a rudimentary outline of the problems involved; it emphasizes the truth that the supply of money influences the price level and may be a cause of inflation.

This is the transactions' form of the quantity equation, originally outlined by Irving Fisher. The value of money can also be considered as determined, like the price of other commodities, by the demand for and the supply of it. The basic equation is then M/PT, where M, P and T have the same meaning as before and it is the proportion of the community's expenditure on goods and services which on the average is held as cash during the period. This is called the 'cash balance' form of the quantity equation, developed by the Cambridge school of economists. Since k i8 the reciprocal of V (e.g. if V is six times per period, then k is one-sixth of expenditure), the differences between the two forms of the equation are not fundamental. But the cash balance approach emphasises that changes in the demand for money (k) may be as important as the quantity of money (M) in determining P and opens the way for a closer examination of the influences governing h.

Keynes analysed these influences as of three kinds. He argued that money was demanded broadly to satisfy three motives the transactions, precautionary and speculative motives. The first refers to money required to pay for current transactions I.e. everyday purchases. The second refers to money demanded as inactive balances held to provide against unforeseen contingencies. The third refers to money held as a pool available to take advantage of movements in the market prices of other forms of wealth (e.g. securities). The simple form of the quantity theory considered only the transactions demand for money. If money were demanded only because of its command over other goods, which remained unchanged in total, P would vary as M. But this simple relationship breaks down if a part or the whole of an increase in M flows into inactive balances (for the precautionary and speculative motives), thus having little or no effect on commodity prices. The simple quantity theory relationship is also weakened by possible variations in T, i.e. in the total out-put of goods and services. It is now generally recognized that the influences determining the general level of prices are more complex than the quantity theory in both forms envisaged.

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