The document discusses the quantity theory of money. It begins by explaining the basic concept that there is a direct relationship between the quantity of money in an economy and the price level. It then discusses Irving Fisher's formulation of the quantity theory through his equation of exchange. Finally, it discusses Milton Friedman's reformulation, which views the quantity theory as a theory of demand for money and emphasizes the role of wealth and asset prices in determining demand for money.

1. By: VIKRAM.G.B
Faculty, P.G dept. of Commerce
Bangalore-55

2.  Value of money refers to the purchasing power of
money over goods and services in a country.
 A relative concept which explains the relationship
between a unit of money and goods and services
which can be purchased with it.
 Internal value of money: It refers to the purchasing
power of money over domestic goods and services.
 External value of money: It refers to the purchasing
power of money over foreign goods and services.

3.  The concept of the quantity theory of money (QTM)
began in the 16th century. As gold and silver inflows
from the Americas into Europe were being minted into
coins, there was a resulting rise in inflation.
 The idea is that, the money supply will directly impact
both prices and inflation rates.
 The quantity theory of money states that there is a
direct relationship between the quantity of money in an
economy and the level of prices of goods and services
sold.
 According to QTM, if the amount of money in an
economy doubles, price levels also double,
causing inflation (the percentage rate at which the level
of prices is rising in an economy). The consumer
therefore pays twice as much for the same amount of
the good or service.

4.  Another way to understand this theory is to recognize
that money is like any other commodity: increases in its
supply decrease marginal value (the buying capacity of
one unit of currency). So an increase in money supply
causes prices to rise (inflation) as they compensate for
the decrease in money‟s marginal value.

5.  Irving Fisher an American economist, put forward the
Cash Transaction Approach to the quantity theory of
money. He in his book The Purchasing Power of Money
(1911) has stated that the value of money in a given
period of time depends upon the quantity of money in
circulation in the economy
 “Other things remaining unchanged, as the quantity of
money in circulation increases, the price level also
increases in direct proportion and the value of money
decreases and vice versa”.
 If the quantity of money is doubled, the price level will
also double and the value of money will be one half. If
the quantity of money is reduced by one half, the price
level will also be reduced by one half and the value of
money will be twice.

6.  In Fisher‟s Cash Transactions Version of Money, the general
price level in a country, like the prices of commodities, is
determined by the supply of and demand for money.
 Supply of Money: The supply of money consists of the
quantity of money in circulation (M) and the velocity of its
circulation (V) i.e., the number of times the money changes
hands. Thus MV refers to the total volume of money in
circulation during a period of time. For example, if the total
money supply in India Rs. 5,000 billion and its velocity per
unit of time is 10 times, then the total money supply would
be Rs. 5,000 x 10 = Rs.50000 billion.
 Demand for Money: People demand money not for its own
sake. They demand money because it serves a medium of
exchange. It is used to carry every day transactions. In
short, the demand for money is for the exchange of goods.

7. Equation of Exchange:
The Cash transaction version of the quantity theory of
money was presented by lrving fisher in the form of an
equation:
P = MV + M1 V1 or PT= MV+ M1V1
T
Here,
P is the price Level
M is the quantity of money
V is the velocity of circulation of M
M1 is the volume of credit money
V1 is the velocity of circulation of M1
T is the total volume of goods and Trade

8. Let us suppose M = Rs. 2000, M1 is Rs = 1000, V =
6, V1 = 4 and T = 8000 goods.

9. In figure 4.1 (a) it is shown that when the supply of money is
increased from QM to QM2, the price level also rises from OP1 to
OP2. As the quality of money increase four times to QM4, the
price level also increases four times to OP4.
In figure 4.1(b) the inverse relationship between quantities of
money in circulation and the value of money is shown. When the
quantity of money is QM1, the value of money is VM1. When the
money supply is doubled from QM1 to QM2, the value of money
is reduced to half from VM1 to VM2.

10.  Full employment: The theory is based on the
assumption of full employment in the economy.
 T and V are constant: The theory assumes that volume
of trade (T) in the short run remains constant. So is the
case with velocity of money (V) which remains
unaffected.
 Constant relation between M and M1. Fisher assumes
constant relation between currency money M and credit
money (M1).
 Price level (P) is a passive factor. The price level (P) is
inactive or passive in the equation. P is affected by
other factors in equation i.e., T, M, M1, V and V1 but it
does not affect them.
 It is assumed that the demand for money is
proportional to the value of transaction.
 The theory is applicable in the long run.

11.  Unrealistic assumptions: The theory is based on
unrealistic assumptions. In this theory P is considered
as a passive factor. T is independent. M1, V, V1, are
constant in the short run. All these assumptions are
covered under “Other things remaining the same.” In
actual working of the economy,
these do not remain constant; Hence, the theory is
unrealized and misleading.
 Various Variables in the transaction are not
independent. As assumed in the theory The fact is that
they very much influence each other For example when
money supply (M) increases the velocity f money (V) also
goes up Take an other case. Fisher assumes (P) is a
passive factor and has no effect on trade (T). In actual
practice, when price level P) rises, it increases profitts
and promotes trade (T).

12.  Assumption of full employment is wrong. J. M. Keynes
has raised en objection that the assumption of full
employment is a rare phenomenon in the economy and
the theory is not real.
 Rate of interest ignored. In the quantity theory of
Fishers, the influence of the rate of interest on the money
supply and the level of prices have been completely
ignored. The fact is that an increase or decrease in money
supply has an important bearing on the rate of interest.
An increase in money supply leads to a decline in the rate
of interest and vice versa.
 Fails to explain trade cycles. The theory fails to explain
the trade cycles. It does not tell as to why during
depression, the increase in money supply has little impact
on the price level, Similarly, in boom period the reduction
in money supply or tight money policy may not bring
down the price level G. Crowther is right in saying, “The
quantity theory is at best an imperfect guide to the cause
of the business cycle”.

13.  Ignores other factors of price level. There are many
determinants other than M, V, and T which have important
implication on the price level. These factors such as
income, expenditure, saving, investment, population
consumption etc have been ignored from the purview of
the theory.
 Weak Theory: According to Crowther, QTM is weak in
many respects.
i. It cannot explain „why‟ there is a fluctuations in the price
level
ii. It gives undue importance to the price level.
iii. Misleading emphasis on the quantity of money as the
principal cause of changes in the price level during the
trade cycle.

14.  Friedman avows that the quantity theory is fundamentally a
theory of the demand for money. It is not a theory of output, or
of money income, or of the price level.
 Friedman regards the amount of real cash balances as a
commodity which is demanded because it yields services to the
person who holds it. Thus money is an asset or capital good,
hence demand for money forms part of capital or wealth theory.
 Acc.to Friedman total wealth includes all sources of income or
consumable services which is capitalized income.
wealth can be held in 5 different forms:
i. Money
ii. Bonds
iii. Equities
iv. Physical goods
v. Human capital

15.  The present discounted value of expected income
flows can be expressed as:
W=y/r
 Where W is the current value of total wealth, y is the
total flow of expected income from the five forms of
wealth and r is interest rate.
 Friedman expands the detail of wealth and returns to
indentify the variety of assets and returns in the potential
portfolio:
M f P , rb , re , ra ,w , ;u
r
 where P is the price level, rb is the return on bonds, re is
the return on equities, ra is the return on real assets, w is
the ratio of human to nonhuman wealth (to capture the
return on “human wealth”), /r is total wealth, and u is the
“portmanteau variable.”

16.  In the theory of QTM by Friedman, the supply of money is
independent of the demand for money. The supply of
money is unstable due to the actions of monetary
authorities. On the other hand, the demand for money is
stable.
 Thus, Friedman presents the quantity theory as the theory
of the demand for money and the demand for money is
assumed to depend on asset prices or relative returns and
wealth or income. He shows how a theory of the stable
demand for money becomes a theory of prices and output.
A discrepancy between the nominal quantity of money
demanded and the nominal quantity of money supplied
will be evident primarily in attempted spending.

17.  Very broad definition of money
 Money not a luxury good
 More importance to wealth variables
 Money supply not exogenous
 Ignores the effect of other variables on
money supply
 Does not consider time factor