Quantity Theory of Money - Explained
What is the Quantity Theory of Money?
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What is the Quantity Theory of Money?
The quantity theory of money, sometimes called "The Fisherian Theory" simply states that a change in price can be related to a change in the money supply. In simple terms, it states that the quantity of money available (money supply) in the economy and the price levels have the same growth rates in the long run. When there is a fall in interest rates or a decrease in taxes and there is little restriction on how money can be accessed, consumers become less sensitive to changes in price, and hence, have a higher propensity to consume. As a result of this, there will be a rightward movement in the aggregate demand curve, and an upward movement in the equilibrium price level.
How is the Quantity Theory of Money Applied?
The quantity theory of money generally assumes that, if there is an increase in the quantity of money which is in circulation in the economy, there will likely be inflation, and vice versa. By examining the activities of the Federal Reserve or European Central Bank (ECB), we can see that if this body increases the supply of money in the economy by twice its normal quantity, there tends to be a sudden increase in prices of commodities in the economy in the long-run. This price increase can be associated with the excess money supply which will create more demand and spending. Although economists don't agree with the assumption of a sudden change in price after a change in the quantity of money in circulation. KEY TAKEAWAYS
- The quantity theory of money is said to be a framework that is used to understand how price changes affect the supply or circulation of money in an economy.
- The quantity theory of money generally assumes that, if there is an increase in the quantity of money which is in circulation in the economy, there will likely be inflation, and vice versa.
- Its most common version is sometimes called the "Neo-quantity Theory" or "Fisherian Theory".
- The relationship between price and the money supply was staunchly rejected by John Maynard Keynes because he felt it didn't take interest rates into consideration.
- It is strongly rejected by the Keynesian but accepted by the Monetarists.
The Irving Fisher Model
The Fisher equation is mathematically expressed as: M (money supply) x V (velocity of money) = P ( average price level) x T ( volume of transactions in the economy). Despite the many strengths of the Fisher model which includes its simplicity and compatibility with mathematical models, its false assumptions usage to arrive at its simple nature which includes; a proportional supply of money, independent variables, and price stability raise doubts. Despite these doubts, there are still economists like the Chicago school of economics' monetary economists who advocate for the theory. Although many economists do not accept the stable increase in the money supply assumption, more economists accept the monetarists' claim that a change in the money supply cannot affect the real economic output in the long-run.
Competing Quantity Theories
The Keynesian economists use a similar framework as the monetarists with little exceptions. The relationship between price and the money supply was staunchly rejected by John Maynard Keynes because he felt it didn't take interest rates into consideration. Fisher's greatest antagonist was Knut Wicksell, a Swedish economist who developed his theories in continental Europe as opposed to Fisher's in the United States and Great Britain. Though he agreed to the relationship between money supply and price, he argued that there will be an uneven price distortion, especially in the capital goods sector if the money supply was artificially induced through the banking system.
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