Custom Search

## Monday, 6 August 2012

### Critically examine the quantity theory of money

QUANTITY THEORY OF MONEY :-
Professor Taussing has defined it in the following words :

"Double the quantity of money and other things remaining the same prices will be twice and the value of money one half. Half the quantity of money prices will be one half and the value of money double."

The theory also assumes that the quantity of money is directly related to goods and services offered for sale over a given period of time and the supply of goods and services remains fixed.
Now we can explain this theory by the following example :
Example : Let us suppose that there is only one hundred (100) rupees in circulation and there are only ten commodities for sale and purchase. All the goods have the same value. So the price of each commodity will be 100/10 = 10 Rs. Further suppose that the quantity of money in circulation double (200). Now the price of each will be Rs. 20. It means the price has doubled but the value of money has reduced to 1/2.

Now further we assume that we reduce the quantity of money from 100 to Rupee 50. Now each commodity price will be 50/10 = 5 Rs. So in this way, the price is reduced to 1/2 but the value of money is doubled.

Professor Fisher has introduced the quantity theory in the mathematical equation and he has also discussed the velocity of circulation of money.

Formula :   P = MV + M'V' / T

P = General price level.
M = Amount of money in circulation.
V = Velocity of circulation.
M' = Credit money issued by bank
V' = The velocity of credit circulation.
T = Total amount of goods and services bought and sold.

Let us suppose the supply of currency in circulation ( M ) is Rs. 100 and the velocity is 3 ( V ). The bank credit ( M' ) in circulation. We assume is also 100 Rs. and its velocity is 2 ( V' ). The total volume of transaction is 100.

The equation is =  P = MV + M'V' / T

P = 100 x 3 + 100 x 2/100  = Rs. 500/100 = 5 Rs.

Now we double the money and credit amount and then check the price level.

P = 200 x 3 + 200 x 2/100 = Rs. 1000/100 = 10 Rs.

According to it prices has doubled by doubling the M. So further if we one half the M, the prices will ab also 1/2.

According to Prof. Fisher, there are three important factors which influence the value of money.
1. Quantity of money.
2. Transaction velocity of money.
3. Volume of transaction.

ASSUMPTIONS :-
Following are the important assumptions :

1. Constant Velocity Of Circulation Of Money :-
Velocity of circulation means that one unit of money how many times passes in different hands. For example if 5 Rs. note passes through five persons, it means the quantity of money will be twenty five. According to this theory it has been assumed that velocity of circulation of money remains constant. There is no change in it.

2. No Change In Credit Money :-
It has been also assumed that credit money ( M' ) in circulation will remain constant.

3. No Changes In The Volume Of Transaction :-

It has been assumed that total goods and services quantity remains constant.

4. No Change In Direct Exchange :-

There should be no change in the volume of direct exchange.

5. No Change In The Hidden Money :-
There should be no change in the quantity of hidden money otherwise this theory will be not be applicable.

CRITICISM ON QUANTITY THEORY OF MONEY :-

1. Useless Assumptions :-
This theory has been assumes that velocity V,V,T remains constant in the short run while the fact is that in real life they change in the long run as well as in the short run.

2. Independent Variables :-
In this equation it has been assumed that M,V and T are independent variables while it is not true. When money changes it brings changes in velocity and in the amount of goods and services.

3. Proportionate Change :-
According to Fisher the increase or decrease in the quantity of money brings proportionate change in the price level. While the history shows that it is not true.

4. Unemployed Resources Case :-
The amount fundamental objection on this theory is that if the we are unemployed resources in a country then an increase in the supply of money will be absorbed in the unemployment resources and production will increase. There will be no rise in the prices level.

According to this theory Govt. can increase  the quantity of money to remove the deflation and decrease the supply of money to control inflation. But in 1930 when great depression took place every country tried her best to increase the quantity of money but the prices did not rise and depression could not be removed.

6. Ignores The Rate Of Interest :-
Another serious defect is that this theory does not take into consideration the influences of the rate of interest on cash balances.

7. Dynamic Treatment :-
Another objection is that it does not treat the problem dynamically. It has failed to explain the processes through which the changes in the quantity of money affect the price level.
After long discussion it seems that this theory is not acceptable but it is fact that it enables us in understanding the fluctuations in the value of money.

Anonymous,

thank you...for this post

Anonymous,