Download QUANTITY THEORY OF MONEY

QUANTITY THEORY OF MONEY
It is a theory about how much money supply
is needed to enable the economy to function.
It states that the demand for money is simply
for spending on foreseeable transactions.
L A W:
Other things remaining the same, if the
quantity of money is doubled, prices would be
doubled, thus the value of money would be
halved.
The identity (equation of Exchange) of
Quantity Theory of Money is:
LIMITATIONS:
1. If V is constant, any growth in M to
increase output T would result in
inflation.
2. T is given because it is assumed that
there is always full employment in the
economy.
3. If T is growing, V is constant, then
matching growth in M is needed to
avoid deflation.
Monetarists argue that an increase in Money
supply will lead directly and quickly to
changes in NI and PI, V b
Where
P = Price level of goods bought and sold;
T = Number of Transactions;
M = Money supply; and
V = Velocity of Circulation.
Velocity of Circulation in Pakistan:
VP k
=
GNPMP (PT) / Average Money Stock
for the Quarter (M)
ASSUMPTIONS:
1. It is assumed that M is both the
quantity of Money demanded and
quantity of Money supplied.
2. V has a roughly constant value.
3. T is either given or it is independent of
the amount of money.
4. The amount of M is determined by the
other factors and is independent of V,
T or (most significantly P).
In this way Quantity Theory of Money
becomes the Theory of Price Levels. Because
since PT=MV, therefore P=MV/T where V, T =
constant. P will vary directly with M i.e. if M
changes Price also changes so inflation would
be directly related to supply.
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NEW QUANTITY THEORY OF MONEY
Friedman restates the quantity theory of money and argued that money is just one of five broad
ways of holding wealth.
The five ways are:
i. Money;
ii. Bonds;
iii. Equities;
iv. Physical goods; and
v. Human wealth.
Each of the above gives some kind of satisfaction or yield to the holder.
Friedman argued that the demand of money is related to the demand of for holding wealth in its
other forms. Money is the direct substitute for wealth in the forms of bonds, equities or physical
goods.
Monetarists believe that people would possibly invest money to earn interest, but they might
also use it instead to buy equities or physical assets.
Monetarist argued that money is a temporary abode of purchasing power waiting to be spent on
other types of financial or physical assets.
The demand for money is therefore a function of the yield on money and the yield on other
forms of holding wealth. Yield here includes non-monetary yields.
Monetarists argue further that the demand for money is fairly interest-inelastic. The demand for
money is related to transaction motive, but not to any speculative motive. An expected rise in
the interest rates might persuade individuals to sell bonds and buy other assets, but not to hold
speculative money.
Monetarists hold the view that the reason for demanding money is for transactions only, not
speculation about future investment. Monetarists argue instead that interest rates are
determined by the demand and supply of Loanable Funds. An increase in the Ms, without any
increase in demand for Money, will increase the amount of Loanable funds available. Interest
rates will fall, and investment will rise.
TRANSMISSION MECHANISM
The mechanism by which changes in demand for and supply of money affects AD is called
Transmission Mechanism. It describes the process whereby any excess of money demanded
over money supplied, or vice versa causes a change in the Aggregate expenditure in the
economy (i.e. change in NI).
The Transmission Mechanism operates in three stages:
i.
The link between monetary equilibrium (Ms = Md) and the interest rates.
ii. The link between the interest rate and Investment Expenditure.
iii. The link between Investment Expenditure and Aggregate Demand.
CONCLUSION:
For Monetarists, changes in the Ms cause changes in the money value of NI.
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