Money and Prices: Quantity Theory of Money

• In economics, value refers to value-in-exchange, meaning the purchasing power of a commodity or what it can obtain in exchange.

• The value of money similarly means its purchasing power over goods and services in general.

• The purchasing power of money depends on the prevailing price level, since higher prices reduce the quantity of goods and services that a unit of money can buy.

• When the price level rises, the value of money falls, and when the price level falls, the value of money rises.

• Therefore, the value of money is inversely proportional to the price level and can be expressed as the reciprocal of the price level.

QUANTITY THEORY OF MONEY: FISHER’S TRANSACTIONS APPROACH

• The quantity theory of money, strongly associated with Irving Fisher, explains the determination of the general price level by linking it directly to changes in the quantity of money in the economy.

• The theory states that, other things remaining constant, the price level varies directly and proportionately with the quantity of money, so that doubling money supply doubles prices and halves the value of money, while halving money supply reduces prices proportionately and raises the value of money.

• The value of money is thus explained in terms of its quantity, implying that fluctuations in money supply are the primary cause of changes in the general price level.

• According to classical and neoclassical economists, the general price level is determined by three main factors: the volume of trade or transactions, the quantity of money, and the velocity of circulation.

• The volume of trade depends on the total output of goods and services, but under the classical assumption of full employment, output is fixed, so total transactions remain constant.

• The quantity of money includes not only currency issued by the government but also bank-created credit and deposits.

• Velocity of circulation refers to the number of times a unit of money changes hands in a year, meaning that higher velocity increases the effective purchasing power of a given money supply.

• The theory can be illustrated numerically: if output is fixed at 2,000 quintals of wheat, money supply is ₹25,000, and velocity is 4, total expenditure equals ₹1,00,000, giving a price of ₹50 per quintal; doubling money supply to ₹50,000 raises total expenditure to ₹2,00,000 and price to ₹100 per quintal, and increasing it to ₹75,000 raises price further to ₹150 per quintal.

• Thus, with constant output and velocity, any increase in money supply leads to a proportional rise in prices, confirming the direct relationship between money supply and the price level.

Fisher’s Equation of Exchange

• Irving Fisher formulated the relationship between money and prices through the equation of exchange, expressed as MV = PT, where M is quantity of money, V is velocity of circulation, P is average price level, and T is total transactions.

• The equation is an accounting identity because total money spent (MV) must equal total money received (PT), but classical economists converted it into a price theory by assuming certain variables to be constant.

• They assumed T (volume of transactions) to be constant due to full employment of given resources, fixed technology, and efficiency, implying that real output does not change in the short run.

• They also assumed velocity of circulation (V) to be constant, determined by institutional factors such as wage payment practices, spending habits, and the development of the banking and credit system, which were believed not to change in the short run.

• With V and T constant, the equation MV = PT implies that the price level (P) varies directly and proportionately with the quantity of money (M).

• The quantity of money is considered exogenously determined by the Government and Central Bank, independent of real factors affecting output or transactions.

• Therefore, changes in money supply are viewed as the primary cause of changes in the general price level.

• Numerical illustration: if M = ₹5,00,000, V = 5, and T = 2,50,000 units, then P = 10 per unit; doubling M to ₹10,00,000 (with V and T constant) raises P to 20 per unit, showing that prices double when money supply doubles.

• Thus, under the quantity theory, price level changes are directly proportional to changes in money supply, making money the decisive factor in determining the general price level.