The quantity theory of money concept examples It is one of the fundamental research areas of the monetary economics branch, and according to the quantity theory of money, the general level of prices for goods and services is proportional to the money supply in the economy. If the amount of money in the economy doubles, price levels will also double. This means that the consumer will pay twice as much for the same amount of goods and services. This rise in price levels will eventually lead to a higher level of inflation (inflation is a measure of the rate at which the prices of goods and services rise in an economy). The same forces that affect the supply and demand of any commodity also affect the supply and demand for money, and when the money supply increases, ceteris paribus, the purchasing power of one unit of currency decreases. As a way to deal with this decrease in the marginal value of money, the prices of goods and services rise, and this leads to an increase in the level of inflation.
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The concept of quantity theory in money The quantity theory of money
The Quantity Theory of Money, which assumes that the amount of money in an economy has a significant impact on the level of its economic activity. Therefore, a change in the money supply leads to either a change in price levels or a change in the supply of goods and services, or both. In addition, the theory assumes that changes in the money supply are the main cause of changes in spending. One implication of these assumptions is that the value of money is determined by the amount of money available in the economy. An increase in the money supply also leads to a decrease in the value of money because an increase in the money supply also leads to an increase in the inflation rate. As inflation rises, purchasing power decreases and the value of a currency is expressed in terms of the amount of goods or services that a single currency can buy. Therefore, when the purchasing power of a currency decreases, it requires more units of the currency to buy the same amount of goods or services.
How to calculate quantity theory in money
The most popular version, sometimes called the “new quantity theory” or Fisher’s theory, suggests the existence of a fixed, mechanically proportional relationship between changes in the money supply and the general level of prices. This popular, though controversial, formulation of the quantity theory of money is based on an equation by the American economist Irving Fisher.
The Fisher equation is calculated as follows:
While the previous symbols express the following:
- M = money supply
- V = velocity of money
- P = Average price level
- T = the volume of transactions in the economy
In general, the quantity theory of money explains how increases in the quantity of money lead to inflation, and vice versa. In the original theory, it was assumed that V is constant and that T is constant with respect to M, so that a change in M directly affects P. In other words, if the money supply increases, the average price level will tend to rise by (and vice versa), with little impact on real economic activity.
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Assumptions of the quantity theory of money
Every theory has hypotheses, conclusions and evidence. The quantity theory of money has the following assumptions:
The first hypothesis of the quantity theory of money
The concept of quantity theory of money is based on certain assumptions that “other things remain the same”. Where V is assumed to be constant and not affected by changes in the quantity of money (M) or the price level (P). The velocity of money (V) also depends on population, business activities, habits of people, rate of interest, facilities for investment, etc. These factors are assumed to have nothing to do with changes in the value of money. Quantity theorists ignored the velocity of money because they were concerned with what Keynes called transactions and the precautionary motives for holding money.
The second hypothesis of the quantity theory of money
The theory is based on the assumption that the volume of goods and services (T) remains constant. Where (T) depends on natural resources, climatic conditions, production techniques, labor productivity, transport, etc. All these factors presumably have nothing to do with changes in the quantity of money. Hence, T remains constant. Since the assumption that the total volume of goods and services (T) is constant depends on another assumption of full employment, that is, idle resources are not available to produce the goods and services to be exchanged for money. not to knit.
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The third hypothesis of the quantity theory of money
Quantity theorists also assume that price is a negative factor. Where the price changes or is affected by other factors in the equation, but does not affect or cause changes to those factors. The relationship between P and other factors in a one-sided equation is determined insofar as P is determined by other elements in the equation. But that does not define it, says prof. Fisher, “Usually the completely negative level of the price is an element of the equation of exchange. It is not controlled by other elements, but exercises control over it.”
The fourth hypothesis of the quantity theory of money
Prof. Fisher assumes the existence of a long period and believes that V and T are constant over a long period. In the short transition period there may be a change in another variable such as T or V. But when this short transitional period or transitional period ends, the other variables will become so constant that a change in M or V will be followed by a proportional change in P. Fisher was also keen to qualify the proportional relationship expressed by the equation of exchange between changes in the quantity of money and a change in the price level is proposed.
How to calculate the demand for money
The exchange equation can also be reformulated in the money demand equation as:
- Md: Refers to the demand for money.
- P: denotes the price level in the economy.
- Q: Refers to the amount of goods and services offered in the economy.
- V: indicates the speed of money.
In the formula, the numerator (P x Q) is the country’s nominal GDP. Moreover, the equation presents a different view of monetary theory because it links GDP to the demand for money (as opposed to Keynesian economists, who believe that interest rates drive inflation).
Examples of Quantity theory in money
Here, dear reader, is an example of the quantity theory in money. For example, if the Federal Reserve (Fed) or the European Central Bank (ECB) doubles the money supply in the economy, long-run prices in the economy tend to rise. This is because more money circulating in the economy will lead to increased demand and spending by consumers, which will lead to higher prices.
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Criticism of Fisher’s quantity theory of money
According to monetarists, a rapid increase in the money supply can lead to a rapid increase in inflation. This is because when the growth of money exceeds the growth of economic output, there is too much money supporting the production of too few goods and services. To stop the rapid rise in the level of inflation, it is therefore necessary that the growth in money supply falls below the growth in economic output.
And when monetarists think of solutions for a great economy that needs a higher level of production. Some monetarists may recommend increasing the money supply as a short-term support. However, the long-term effects of monetary policy are not expected, so many monetarists believe that the money supply must remain within an acceptable bandwidth so that inflation levels can be controlled.
Instead of governments constantly adjusting their economic policies through government spending and tax levels, monetarists recommend allowing non-inflationary policies such as a gradual reduction in the money supply to drive the economy to full employment.
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The modern quantity theory of money
Modern quantity theory of money predicts that the demand for money should not only depend on the risk and return that money offers, but also on the various assets that households can hold in place of money. So that the demand for money must depend on the total wealth. The reason is that wealth measures the size of the portfolio that will be allocated between funds and alternative assets. The money demand function is therefore essentially a function of wealth (W). There are two alternative forms in which wealth can be held:
- (1) Effects.
- (2) Equity (shares).
(M/P)d = L (rs, rb, ne, W)
- where rs is the expected real return on the share.
- rb is the expected real return on the bond.
- W is a real fortune.
- M → Token cash request.
- P → price level.
And to explain the previous equation that the demand for money depends on the yield on bonds and stocks. Inflation affects the amount of wealth held. Therefore, Md depends on the return on the bonds and shares. Inflation affects the amount of wealth held.
- If rs or rb increases, the demand for money falls because other assets become more attractive.
- If the FT increases, the demand for money decreases because money becomes less attractive.
- If W increases money because higher wealth means larger portfolio.
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