The Quantity Theory of Money (QTM) is an important theory in classical macroeconomics and it is defined as ‘predicting that the price level and quantity of money vary inexact proportions to each other’ (Lipsey and Chrystal, 2015) so the general price is directly proportional to the money supply. The classical view sees a separation between real variables such as employment, real GDP and nominal (monetary) variables such as prices, wages, and exchange rates, this known as the classical dichotomy. In the classical dichotomy, real factors determine real variables and monetary factors determine the monetary variables (Trevithich,1992). This theory is regarded as being “the hallmark of classical macroeconomic theory’’ (Snowdon, Vane, & Wynarczyk, 1994). Money, therefore is seen as being neutral and as a veil as it only affects prices and not output. This is different to the Keynesian school of thought which was brought by John Maynard Keynes in his book The General Theory of Employment, Interest and Money which argued against the famous dichotomy thus viewing money as having a store of value and not being a veil as it can affect real variables such as output and employment. Keynes put forth his own theory, the liquidity preference theory which I will compare against the Quantity theory of money in this essay alongside discussing his analysis of the QTM.
Before explaining the classical view, it is important to understand what is money and its uses. Money is describes as being ‘’the stock of assets that can be readily used to make transactions.’’ (Mankiw, p. 2006) having three functions. The first function is that money has a store of value, so people store money so they can trade it for goods and services. Secondly money is unit of account which is used to measure transaction in the economy. The lastly money is seen as a medium of exchange used to buy goods and services.
Classical View
There are two forms of the Quantity Theory of Money the Fisher’s transmission approach and the Cambridge cash-balance approach which is associated with Cambridge writers Marshall and Pigou.
Transmission Approach
First Irving Fisher’s transmission approach, he concentrated on all money transactions which took place in specified period in an economy (Trevithick,1992). The equation of exchange is MV=TP; where M is quantity of money and V is defined as the velocity of circulation (number of times money turns over in a given time period), T is the number of transactions conducted and P is the price level- the average price at which sales happen. Value of all sales (TP) must equal value of all purchases (MV) as every transaction has a buyer and a seller.
An assumption made in the Fisher’s version of QTM is that money supply (M) is exogenously set by the central bank and independent to TP (value of sales). Another assumption is that V is ‘institutionally determined datum in short to medium run’ (Trevithich,1992) so V is assumes constant as the institutional components which determine V does not vary in short to medium run. It is also assumed that T is constant in short run as transactions are determined by factors of production such as labour and since T depends on Y (output/income) which is assumed at full employment level of output (Trevithich,1992). Since T and V are both assumed as being constant this implies that an increase in money supply would lead to a proportional increase in prices. For example, if the money supply was doubled you would also see a doubling in the general price level causing inflation.
There is also the income version of Fisher’s equation where T is replaced by Y. This shows all transactions which involved the expenditure and output of country where intermediate transactions removed (Trevithick,1992). The equation is MV’=P’Y where P’ is GDP inflator and Y is real GDP and so PY is the nominal GDP.V’ defined as the income velocity of circulation of money which is the number of times money enters a person’s income in given period (Mankiw,2006). There are the same assumptions as the other version of Fisher’s equation thus an increase in money supply leads to proportional increase in prices due to other variables, Y and V being fixed.
Cambridge Cash-Balance Approach
In the Cambridge cash-balance approach money is not only a means of exchange like in Fishers’ approach, money can also have a store of value and can held as an asset. They argue that the value of money is solely reliant on money demand and that the demand for money is determined by the need to carry out transactions which will have a positive correlation to the value of money in terms of aggregate expenditure. (Snowdon and Vane, 2005) The equation is Md=kPY (Snowdon and Vane,2005) where Md is money demanded in economy,Y as we know is output and k states the ratio of money income that people wish to hold for convenience and safety (Trevithick, 1992). At equilibrium money demand equals money supply (Md=M), so the equation also be written as M=kPY.
If, however, there is an increase in the money supply by the government (expansionary monetary policy), this will cause a disequilibrium in the money market where the money supply is greater than money demand. Households will find themselves holding more cash which will lead to more transactions and more purchases of goods and services, this is known as the Pigou effect. This excess supply of money will create an excess demand for goods and services but since output is predetermined at full employment level the supply of goods and services are restricted so this excess demand will only lead to a rise in general price level which is proportional to the rise in money supply. Since K is the reciprocal of velocity of circulation (k=1/V) so also assumes it is also constant and Y both assumed to be constant, therefore just as in Fishers’ version money supply determines prices and are directly proportional.
Keynesian view
Keynes rejected the quantity theory of money and argued that real and nominal (monetary) variables are not separate but are linked and that monetary variables do effect real variables, through the interest rate, disagreeing with the classical dichotomy. Keynes argues that velocity of transactions (V) is not constant as is assumed in the classical model, for example in times of depression people may not be willing to spend money due to lower income so the times in which money circulates in economy is not fixed. He also argued that transactions (T) also cannot be assumed constant, classical believe it is determined by employment and that output is at full employment level, however Keynes believed there could be an equilibrium where output is not at full employment. In the classical the quantity of real output (Y) is predetermined by the impact of both the labour market and Say’s Law, Keynes rejected both of these thus his theory doesn’t assume that Y is predetermined at its full employment level. (Snowdon and Vane, 2005)
Keynes rejected the idea that people held money for only transactional purposes, he believed that there were three demands for money:
1. The transactional demand for money, which is a function of income for use to buy goods and services
2. The precautionary demand for money which is also a function of income to guard unexpected events and emergencies.
3. The speculative demand for money which is a function of interest rate where is money is a financial asset.
(Johnson, Ley, & Cate, 2001)
Keynes introduced the speculative demand and believed money has a store of value not just a veil used for only exchange. Keynes’ theory is liquidity preference theory, which says ‘the demand for money is not to borrow money but the desire to remain liquid.’ (Agarwal,2018) so the speculative demand of money is a function of expectations determined by the interest rate. Bonds are an asset that have a promise to pay owner a certain amount of each year, this is known as the bond yield. When the interest rate decreases people expect an increase in the future and as bond price and interest rate are inversely related as the interest rate rises the expected price of bonds falls. This may lead people to sell off bonds to avoid making a loss, when people sell bonds liquidity preference decreases. If everybody believes that current interest rate is lower than normal interest rate. There is a risk of a liquidity trap as there is a higher demand for money for speculative motives and the interest rate is so low people prefer to hold money so a lower liquidity preference. Monetary policy therefore loses its effectiveness if there is a liquidity trap as the money demand curve will be flat (perfectly elastic) so increases in money supply will have no effect on interest rate. This is demonstrated in graph 1 below, where the outward shift to the right in money supply curve by expansionary monetary policy has no effect on the interest rate.
Graph 1; showing relationship between money supply and money demand in Keynesian model
source: Sanket Suman,n.d.
Conclusion
The Quantity Theory of Money argued that money was neutral and was a veil which was only a medium of exchange and didn’t have any effect on real variables such as output and employment, only affecting monetary variable such as the price level. This what we have come to understand is the classical dichotomy. This classical view was demonstrated in both Fisher’s and the Cambridge writers’ versions of the Quantity Theory of Money, where changes in money supply produced a proportionate change in general price level. Keynes disagreed with the classical model and stating that money does have an effect on the interest rate in the speculative demand for money which effects real variables such as investment and output thus dismantling the classical dichotomy.
The quantity theory of money tried to explain the role of money in the economy however it did have some faults as it relies on many assumptions which may not be the true case; such as the assumption that velocity of circulation being constant, this I believe is unrealistic for example in times of depression people may be more likely to hold on to money due to reduced income, so the amount money which turns over in the economy may not always be fixed. Another problematic assumption is that output is at full employment level, however we do find involuntary unemployment in real life and this is due faults is in the labour market, which is one reason why I believe the Keynesian model is more realistic as their equilibrium doesn’t need to be at full employment. Another reason why I think the Keynes theory provides a more accurate picture on how people deal with uncertainty today and that markets have collapsed due to speculative trading and this is esstenial in understand the current financial market (Shahrul Hamden,n.d.).