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The Quantity Theory of Money seeks to explain the factors that determine the general price level in a

country. The theory states that the price level is directly determined by the supply of money. There are two
versions of the Quantity Theory of Money: (1) The Transaction Approach and (2) The Cash Balance
Approach. Let us discuss them in detail.
The Transaction Approach:
Fishers transaction approach to the Quantity Theory of Money may be explained with the following
equation of exchange.
MV = PT
Where, M is the total supply of money
V is the velocity of circulation of money
P is the general price level
T is the total transactions in physical goods.
This equation is an identity, that is, a relationship that holds by definition. It means, in an economy the
total value of all goods sold during any period (PT) must be equal to the total quantity of money spent
during that period (MV). Fisher assumed that (1) at full employment total physical transactions T in an
economy will be a constant, and (2) the velocity of circulation remain constant in the short run because it
largely depends on the spending habits of the people. When these two assumptions are made the
Equation of Exchange becomes the Quantity Theory of Money which shows that there is an exact,
proportional relationship between money supply and the price level. In other words, the level of prices in
the economy is directly proportional to the quantity of money in circulation. That is, doubling the total
supply of money would double the price level.
It may be noted that the above Fishers Equation include only primary money or currency money. But
modern economy extensively uses demand deposits or credit money. It was on account of the growing
importance of credit money that Fisher later on extended his equation of exchange to include credit
money.
Fishers Transaction Approach can explain the causes of hyperinflation that occurs during war or
emergency. It can also explain certain long term trend in prices. But it cannot explain normal peace time
inflation. This shortcoming has been modified by the Cambridge version or the Cash-Balance Approach.
The Cash-Balance Approach: The Cash-Balance Approach to the Quantity Theory of Money may be
expressed as:

p = kR/M (1)
where p = the purchasing power of money
k = the proportion of income that people like to hold in the form of money;
R = the volume of real income; and
M = the stock of supply of money in the country at a given time.
This equation shows that the purchasing power of money or the value of money (p) varies directly with k
or R, and inversely with M.
Since p is the reciprocal of the general price level; that is p = 1/P, the equation, p = kR/M can be
expressed alternatively as:
1/P = kR/M ..........(2)
or M = kRP ...(3)
If we multiply the volume of real income (R) by the general price level(P), we have the money national
income(Y). Therefore,
M = kY .........(4)
where Y is the countrys total money income. We can also write equation (3) in terms of the general price
level thus:
P = M/kR ...........(5)
This equation implies that the price level (P) varies inversely with k or R and directly with M.
In the Cash Balance approach k was more significant than M for explaining changes in the purchasing
power (or value) of money. This means that the value of money depends upon the demand of the people
to hold money.
SUPERIORITY OF THE CASH BALANCE APPROACH
The Cash Balance approach to the Quantity Theory of Money is superior to the Transaction Approach on
the following grounds.
1. The Transaction approach emphasizes the medium of exchange function of money only. On the other
hand, the Cash Balance approach stresses equally the store of value function of money. Therefore, this
approach is consistent with the broader definition of money which includes demand deposits.

2. In its explanation of the determinants of V, the Transaction approach stresses the mechanical aspects
of the payments process. In contrast, the Cash Balance approach is more realistic as it is behavioral in
nature which is built around the demand function for money.
3. As to the analytical technique, the Cash Balance approach fits in easily with the general demandsupply analysis as applied to the money market.
This feature is not available in the Transaction approach.
4. The Cash Balance approach is wider and more comprehensive as it takes into account the income
level as an important determinant of the price level. The Transaction approach neglected income level as
the determinant of the price level.
5. According to the Transaction approach, the change in P is caused by change in M only. In the Cash
Balance approach P may change even without a change in M if k undergoes a change. Thus k, according
to the Cash Balance approach is a more important determinant of P than M as stressed by the
Transaction approach.
6. Moreover, the symbol k in the Cash Balance approach proves to be a better tool for explaining trade
cycles than V in Fishers equation.

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