He believes that the present inflationary rise in prices in most of the countries of the world is because of expansion of money supply much more than the expansion in real income. Thus the theory is one-sided. Holding of money is useless. The quantity theory of money is based on the following assumptions: 1. Though the theory was first stated in 1586, it received its full-fledged popularity at the hands of Irving Fisher in 1911. Fails to Explain Trade Cycles: The quantity theory does not explain the cyclical fluctuations in prices.
Cheap money policy is advocated during depression to raise prices. In order to curb inflation, money growth must fall below growth in economic output. Full employment is a rare phenomenon in the actual world. V not Constant: Further, Keynes pointed out that when there is underemployment equilibrium, the velocity of circulation of money V is highly unstable and would change with changes in the stock of money or money income. But it is not proved by experience that there is a proportional relationship between M and M 1. The intersection of the money supply curve and the money demand curve shows both the equilibrium value of money as well as the equilibrium price level.
Opponents of the theory has argued that the theory falls short, as it does not take into consideration the demand for money, simply the supply assuming it is not put in practice under the neoclassical model with zero regulatory interference where supply would be set equal to demand , and that prices tend to be sticky in the short run. Obviously, larger the incomes of the individual, greater is the demand for cash or money balances. Similarly, an increase in T will reduce the price level. For example, the cause of hyperinflation in Germany in 1923 was not so much due to the increase in M but due to the increase in V for everyone tried to spend a rapidly depreciating mark as quickly as possible. The Quantity Theory of Money states that money supply has a direct, proportional relationship with prices. A fall in the price level raises the real value of cash balances which leads to increased spending and hence to rise in income, output and employment in the economy. T is the total goods and services transacted.
This additional expenditure, given full employment, raises the price level. T also remains constant and is independent of other factors such as M, M, V and V. There always exist inactive balances which exert no pressure on the prices of goods and services. In fact, the quantity theory of money is a hypothesis and not an identity which is always true. It assumes that of the four variables M,V, P and T in the equation, only Mean change on its own initiative.
This theory conveys a basic truth that when a change in the quantity of money circulating in the market is not accompanied by a change in any other relevant variable, the result will be a proportionate change in the price level. Based on this discussion, it seems reasonable to take the quantity theory of money, where a change in the money supply simply leads to a corresponding change in prices with no effect on other quantities, as a view of how the economy works in the long run, but it doesn't rule out the possibility that monetary policy can have real effects on an economy in the short run. It is a hotchpotch price level, which is of no use to anyone. Similarly, when the value of money is high, consumers demand little money because goods and services can be purchased for low prices. Figure 1 depicts the money market in a sample economy. In this sense, the equation of exchange is not a theory but rather a truism. It has been experienced that changes in the velocity of money is of greater importance than changes in the quantity of money.
In a modern capitalist economy, less than full employment and not full employment is a normal feature. The theory suffers from several conceptual problems. Because rising prices give profit incentives to business expansion, a rise in P tends to raise T which may cause an increase in the quantity of money and its velocity of circulation. In particular, the idea of full employment and that expenditure will remain stable are unrealistic. We know that intrinsically, a dollar bill is just worthless paper and ink. The theory is applicable in the long run.
However, this basic truth does not need any sophisticated theory to prove the point. Later, ardent monetarists, including Friedman, admitted that V could change as a consequence of variations in M. While accepted for decades, it was challenged by Keynesian economics. These assumptions, however, have been criticized, particularly the assumption that V is constant. Third, it places a misleading emphasis on the quantity of money as the principal cause of changes in the price level during the trade cycle.
For stability in price level money supply should grow in proportion to increases in output. How to estimate quantity of money which is a stock variable over a period of time? The effect on prices is also not predictable and proportionate. Some examples are given below: i Changes in the level of efficiency wages may change costs of production and affect prices, ii If increase of output occurs under conditions of diminishing returns marginal costs will rise and prices will rise. The demand for money is equal to the total market value of all goods and services transacted. But it cannot be accepted today that a certain percentage change in the quantity of money leads to the same percentage change in the price level.
The money supply is exogenous 3. According to Keynes, an increase in money supply is tantamount to an increase in effective demand. But, in reality less-than-full employment prevails and an increase in the money supply increases output T and employment. The quantity theory of money states that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services sold. By examining the core the theory and running real economic data, a conclusion on its validity, in part or whole can be made. Demand for Money: Money is demanded not for its own sake i.
Similarly prices will fall if production increases under conditions of increasing returns, iii Increase and decrease of monopoly power will respectively increase and decrease prices. Price Level is a Passive Factor: According to Fisher the price level P is a passive factor which means that the price level is affected by other factors of equation, but it does not affect them. Thus, any change in the supply of money M will have no effect on T. Like most things in economics, there is a market for money. If T and V are not taken as fixed the direct link between money and prices is lost and a broader range of economic considerations enters the analysis. The Quantity Theory is defective because it fails to explain the process by which changes in the amount of money affect the price level.