What is the Quantity Theory of Money?
The Quantity Theory of Money asserts that there is a direct relationship between the price level and the amount of money in circulation in an economy. The importance of money in the economy cannot be overemphasised. Money is used as a medium of exchange, a unit of account, a store of value and a standard of deferred payment. The theory explains how the money supply affects inflation. A rise in the money supply would lead to a rise in the price level. When the money supply increases, and the total output of goods and services remains unchanged, individuals will have more money to spend, leading to higher demand and thus higher prices. A decrease in money supply can lead to a fall in price level (deflation).
Monetarists, restating the theory, believe that inflation is caused by an increase in the money supply. They are, therefore, of the opinion that the priority of the government is to control the money supply. This is because the amount of money in circulation is a determinant of inflation and total expenditure (nominal Gross Domestic Product) in an economy.
The Equation of Exchange
The Quantity Theory of Money is explained by the Equation of Exchange. The equation shows the relationship between the money value of expenditure and the money value of an economy’s output (nominal GDP). The popular version is by Irving Fisher, an American economist. It is stated below.
MV = PT
Alternatively, the equation be stated as:
MV = PY
where
M= money supply
V= velocity of circulation
P= general price level of transactions in an economy
T= total number of transactions in an economy over a period of time
Y= output or real GDP or real national income
Money supply means the total amount of money in an economy. The number of times each unit of currency is spent on products in a year is the velocity of circulation.
Both sides of the equation are equivalent as they represent total expenditures in an economy. MV is the total expenditure on goods and services in the economy. PY is the nominal or money GDP, that is, the value of goods and services produced measured at current prices. The total money spent on the economy’s output must be equal to the value of the output produced.
It is assumed that V and T/Y are constant or unchanged in the short run. Therefore, the money supply (M) is directly proportional to the price level (P). An increase in money supply would lead to a proportional increase in the price level and vice versa. For instance, a 3% rise in money supply increases the price level by 3%.
Assumptions of the Quantity Theory of Money
Velocity of circulation is constant
It is assumed that the rate at which money changes hands in the economy remains stable.
Changes in money supply affect only prices
In the long run, changes in money supply affect only prices, not real variables such as output or employment.
Output is unchanged
The output or real GDP is constant. The economy is assumed to be operating at full capacity and output cannot increase in response to a higher money supply.
Closed Economy
The theory often assumes that there is no international trade or capital flows that could influence the money supply.
Efficiency of the banking system is constant
The institutions and technology are assumed to be stable. The efficiency of the banking system and payment mechanisms is assumed to be constant.
Criticisms of the Quantity Theory of Money
Unrealistic Assumptions
It is difficult for an economy to always operate at full capacity. In addition, constant velocity of circulation is unrealistic. In times of recession, for example, money circulation may be slow, and output may be far below full capacity.
Not applicable in the short-run
It has been proven that changes in money supply do not immediately or proportionally affect prices. The relationship is often delayed and influenced by other macroeconomic variables.
Price level is not only determined by the money supply
The price level is also influenced by aggregate demand, production costs, and expectations, not merely by money supply.
Neglect of Interest Rates
The theory overlooks the role of interest rates in influencing the money supply and the general price level. High interest rate reduces borrowing, money supply and price level.
Ignores credit creation by banks
Banks play a crucial role in determining the effective money supply through credit creation, something which is not addressed by the theory. Banks can expand the money supply by lending deposits multiple times.