The quantity theory of money
In the 17th Century it was noticed that there was a connection between the quantity of money and the general level of prices, and this led to the formulation of the Quantity Theory of Money. In its crudest form is stated that an increase in the quantity of money would bring about an appropriate rise in prices. If the quantity of money was doubled, prices would double and so on. Algebraically, this could be stated as:
P = a M
Where a is constant, P the price level, and M the supply of money. If the supply of money doubled, to 2M, the new price level P will equal
a(2m) = 2(aM) = 2P
that is, double the old price level.
After being long discarded, the theory was revived in the 1920s by Professor Irving Fisher, who took into account the volume of transactions, that is to say, the amount of "work" that the money supply had to do as a medium of exchange. That is the velocity
of circulation. Money circulated from hand to hand. If one unit of money is made to serve four transactions, this is equivalent to four units of money, each being used in only one transaction.
As modified by Irving Fisher, the quantity theory came to be expressed by the equation of exchange.
MV = PT
The symbol M represents the total amount of money in existence - bank notes etc, and bank deposits.
The symbol V represents the velocity of circulation, i.e. the number of times during the period each unit of money passes from hand to hand in order to affect a transaction. Thus if the amount of money in the hands of the public during the year was an average $1,000,000 and each dollar on average was used five times, the total value of transactions carried out during the year must have been $5,000,000.
MV therefore represents the amount of money used in a period.
On another side of the equation, P stands for the general price level, a sort of average of the price or all kinds of commodities-producers' goods as well s consumer's goods and services. The symbol T is the total of all transactions that have taken place for money during the year.
The equation of exchange shows us that the price level, and, therefore, the value of money, can be influenced not only by the quality of money but also by:
i. the rate at which money circulates, and
ii. the output of goods and services.
Thus prices may rise without any change taking place in the quantity of money if a rise occurred in the velocity of circulation. On the other hand, prices might remain stable in spite of an increase in the quantity of money if there was corresponding increase in the output of goods and services.
Even in its revised form, however, the Quantity Theory has been subjected to the following criticisms:
a. It is not a theory at all, but simply a convenient method of showing that there is certain relationship between four variable quantities - M, V, P and T. it shows that only the total quantity of money, as determined by the actual amount of money in existence the velocity of circulation, is equal to the value of total trade transactions multiplied by their average price. As such it is obviously a truism, since the amount of money spent on purchases is obviously a truism, since the amount of money spent on purchases is obviously equal to the amount received from sales. Not only must MV be equal to PT, but MV is PT, since they are only two different ways of looking at the same thing.
b. Even if the equation of exchange is only a truism, it would not be quite correct to say that it demonstrates nothing. For example, it shows that it is possible for there to be an increase in the quantity o f money without a general rise in prices. It informs us, too, that if there is to be a change in one or more of the variables of the equation, there must be a change in one or more of the other variables. Cleary, it would be wrong to read into it more than this.
c. The four variables, M, V, P and T, are not independent of one another as the equation of exchange implies. For example, a change in M is likely of itself to bring a change in V or T or both. It is probable that a rise in pries will follow an increase in the quantity of money, but this will most likely be brought about because the increase in the quantity of money stimulates demand and production.
d. A serious defect is to allow the symbol P to represent the general price level. Price changes do not keep in step with one another. In its original form the equation was criticized because it implied that an increase in the quantity would automatically bring about a proportionate increase in all prices. A study of price changes shows that some prices increased by many times while others by fewer times. Clearly, then, there is no general price level, but instead, as the index of Retail Price shows, a number of sectional price levels, one for food, another for clothing, another for fuel and light, and so on.
e. The Quantity Theory only attempts to explain changes in the value of money, and does not show how the value of money is in the first place determined.
f. The Quantity Theory approaches the question of the value of money entirely from the supply perspective.