# transaction approach of quantity theory of money

As regards, aggregate supply curve, due to the assumption of wage-price flexibility, it is perfectly inelastic at full-employment level of output as is shown by the vertical aggregate supply curve AS in Fig. The quantity theory of money was initially known as the equation of exchanged. 20.1 through aggregate demand and aggregate supply model. It will be seen from Fig. 12th. It is supported and calculated by using the Fisher Equation on Quantity Theory of Money. Here, M stands for the total supply of money. Prof. Robertson’s equation is considered better than that of Pigou as it is more comparable with that of Fisher. Let us discuss them in detail. (a) Fisher’s Quantity Theory of Money: The quantity theory of money is a very old theory. It is thus clear that if the volume of transactions, i.e., output to be exchanged remains constant, the price level rises with the increase in the quantity of money. It states that general price level is function of money supply. In practice it has been found that proportionality factor k or- velocity of circulation has not remained constant but has been fluctuating, especially in the short run. 1. According to cash balance approach, the public likes to hold a proportion of nominal income in the form of money (i.e., cash balances). According to them, velocity of money changes inversely with the change in money supply. The following criticisms have been levelled against the quantity theory of money lay by Keynes and his followers: With the qualification that velocity of money (V) and the total output (T) remain the same, the equation of exchange (MV= PT) is a useless truism. In his theory of demand for money, Fisher attached emphasis on the use of money as a medium of exchange. Thus, from equation (3) it follows that with k and Y remaining constant price level (P) is deter­mined by the quantity of money (M); changes in the quantity of money will cause proportionate changes in the price level. Where, M – The total money supply; V – The velocity of circulation of money. It may be noted that even in this income version of the quantity theory of money, the function of money is considered to be a means of exchange as in the transactions approach of Fisher. According to the theory, MV=PT. Privacy Policy 8. The quantity theory of money is an important tool for thinking about issues in macroeconomics. Which is income version of Fisher’s quantity theory of money? Since ex post it must always be true, it is also a truism. Like Fisher’s approach, cash balance approach also assumes that full- employment of resources will prevail due to the wage-price flexibility. Of course, at full-employment level every further increase in spending or aggregate demand must lead to the rise in the price level as output is inelastic in supply at full-employment level. It is supported and calculated by using the Fisher Equation on Quantity Theory of Money. Suppose money supply is increased to M1 at the initial price level P0 the people will be holding more money than they demand at it. It follows from above that k = 1/V. The quantity theory of money seeks to explain the value of money in terms of changes in its quantity. By income velocity we mean the average num­ber of times per period a unit of money is used in making payments involving final goods and services, that is, national product or national income. 10, 00,000 then: P = 10, 00,000 × 5/ 2, 50,000 = Rs. Money and Banking. Further, it is assumed that quantity of money in the economy depends upon the monetary system and policy of the central bank and the Government and is assumed to be autonomous of the real forces which determine the volume of transactions or national output. For example, if the amount of money in an economy doubles, QTM … If spending does not increase, there is no question of a change in prices or output. 3. 20.2 where demand for money is shown by a rising straight line kPY which indicates that with k and Y being held constant demand for money increases proportionately to the rise in price level. Consider a closed economy. According to some economist, the two quantity equation are fundamentally the same. This is not to say, however, that changes in the quantity of money have no influence whatso­ever on the volume of aggregate spending. the quantity theory of money, which in its simplest and crudest form states that changes in the general level of commodity prices are determined primarily by changes in the quantity of money in circulation. In the QTM, PT is treated as the dependent variable. On the other hand, k in the cash balance approach is behavioural in nature. There are several forces that determine the value of money and the general price level. Fisher’s approach is one-sided because it considers quantity of money to be the only determinant of the value of money or the price level. 50 per quintal. If the supply curve of output is fairly elastic, it is more likely that effect of an increase in spending will be more to raise production rather than prices. Like Fisher’s approach if considers substitution between money and commodities. A simple formula governs monetary theory, MV = … When money value of ail such transactions, whether of goods, services, or assets, etc. In fact, income velocity of money is measured by Y/M where Y stands for real national income and M for the quantity of money. Login. Further, according to them, changes in velocity of circulation (VO and price level (P) do not cause any change in volume of transactions except tempo­rarily. V stands for the transactions velocity of circulation of money. Content Filtrations 6. Volume of transaction. Now, rearranging equation (2) we have cash balance approach in which P appears as dependent variable. the quantity theory of money, which in its simplest and crudest form states that changes in the general level of commodity prices are determined primarily by changes in the quantity of money in circulation. Absolute price is determined in the money market and the relative price is determined in the goods market. At a lower rate of interest, people will be induced to hold more money as idle cash balances (under speculative motive). Under this assumption, the entire increase in the quantity of money must express itself in the form of increased spending. Further, velocity of circulation of money also depends on the development of banking and credit system, that is, the ways and speed with which cheques are cleared, loans are granted and repaid. Conversely, the price level falls proportionately with a given decrease in the quantity of money, other things remaining the same. Join Now. Fisher’s theory explains the relationship between the money supply and price level. The Cambridge equation formally represents the Cambridge cash-balance theory, an alternative approach to the classical quantity theory of money.Both quantity theories, Cambridge and classical, attempt to express a relationship among the amount of goods produced, the price level, amounts of money, and how money moves.The Cambridge equation focuses on money demand instead of money supply. That is why it is also called equation of exchange. The equation (1) or (2) is an accounting identity and true by definition. It is worth mentioning that k in the equations (1) and (2) is related to velocity of circulation of money V in Fisher’s transactions approach. 100 per quintal. PreserveArticles.com is an online article publishing site that helps you to submit your knowledge so that it may be preserved for eternity. Then, MV T will also give the money value of total transactions during the same period. Therefore, they would want to reduce their money holding. In the words of Fisher's, "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". 2. In the QTM it is assumed that the physical volume of transactions (T) is determined by the basic physical and operational characteristics of the system, such as the real resources available to the economy, the efficiency with which they are used, the degree of business integration of the economy (which determines the number of transactions involved in the production and sale of final goods). Fisher’s equation of exchange simply tells us that expenditure made on goods (MV) is equal to the value of output of goods and services sold (PT). Thus Fisher‘s transaction approach to the Quantity Theory of Money may be explained with the following equation of exchange. Thus, on rearranging equation (2) we have. In other words, it represents the number of times a dollar is used to purchase goods and services. (ii) The resulting increase in spending or aggregate demand must face a totally inelastic out­put. It was left to J.M. Alfred Marshall and the Quantity Theory of Money In his Fabricating the Keynesian Revolution , David Laidler (1999, 79-80n) notes that Alfred Marshall never claimed to be a quantity theorist. The real trouble is that these things seldom remain the same. Quantity Theory of Money: Fisher’s Transactions and Cambridge Cash Balance Approach! Complete Theory: The cash balances version of quantity theory is superior to the transactions version because the former determines the value of money in terms of the demand and supply of money. Transaction velocity of money. 2. That is, velocity of circulation of money is four. TOS PreserveArticles.com: Preserving Your Articles for Eternity, Two kinds of velocity of money may be distinguished: transactions velocity and income velocity, Superiority of Cambridge Quantity Theory of Money Over Fisher’s Version, The Quantity Equation in Income Form | Money and Prices, Notes on Assumption in Fisherian Analysis of Quantity Theory of Money, Short Essay on the Transactions Approach of Money, Majors Criticism against the Quantity Theory of Money an Appraisal, Controlling in Management # Meaning, Definition, Types, Process, Steps and Techniques. Therefore, in later years quantity theory was formulated in income from which considers real income or national output (i.e., transactions of final goods only) rather than all transactions. According to some economist, the two quantity equation are fundamentally the same. Now consider the left-hand side of equation MVT=PTT (12.1). Fisher’s Transaction Approach and Cambridge Cash Balance Approach. 4. 4. Cambridge economists explained the determination of value of money in line with the determination of value in general. Hence, the velocity of money is the number of times a unit of money changes hands during ex­changes in a year. The transaction approach to... economics. It is the quantity of money which determines the general price level and the value of money. And T stands for transactions in physical goods. Y = Real national income (or aggregate output)Like that in the transactions approach, in this new income ver­sion of the quantity theory also the different variables are assumed to be independent of each other. The quantity theory is in the first instance a theory of the demand for money. When there is a change in the supply of money, there is a proportional change in the price level and vice-versa. Copyright. Fisher’s transactions approach lays stress on the medium of exchange function of money, that is, according to its people want money to use it as a means of payment for buying goods and services. As prices rise, the households will need and demand more money to hold for transaction purposes (i.e., for buying goods and services). Thus, for equilibrium in the money market. For example if 5 Rs. The quantity theory of money also assumes that the quantity of money in an economy has a large influence on its level of economic activity. The quantity theory of money holds if the growth rate of the money supply is the same as the growth rate in prices, which will be true if there is no change in the velocity of money or in real output when the money supply changes. Copyright 10. Hence, it also believes the aggregate supply curve as perfectly inelastic at full-employment level of output. 20.1 that with the increase in aggregate demand to AD2 consequent to the expansion in money supply to M2, excess demand equal to EB emerges at the current price level OP1. The theory that increases in the quantity of money leads to the rise in the general price was effectively put forward by Irving Fisher.’ They believed that the greater the quan­tity of money, the higher the level of prices and vice versa. 2. Further, in explaining the factors which determine velocity of circulation, transactions approach points to the mechanical aspects of payment methods and practices such as frequency of wages and other factor payments, the speed with which funds can be sent from one place to another, the extent to which bank deposits and cheques are used in dealing with others and so on.