CH 19

QUANTITY THEORY OF MONEY

Velocity of Money and Equation of Exchange
Irving fisher developed a transactions-based theory of the demand for
money in which the demand for money in which the demand for real
balances is proportional to real income and is insensitive to interest-rate-
movements. An implication of his theory is that velocity, the rate at which
money turns over, is constant. This generates the quantity theory of
money, which implies that aggregate spending is determined solely by
movements in the quantity of money.
Quantity Theory
Fishers view that velocity is fairly constant in the short run transforms the
equation of exchange into the quantity theory of money, which states :
When the quantity of money M doubles, M x V doubles and so must P X Y,
the value of nominal income.

IS VELOCITY A CONSTANT ?
The classical view that velocity can be effectively treated as a constant is
not supported by the data. The non constancy of velocity became
especially clear to the economics profession after the sharp drop in
velocity during the years of the Great Depression
Transactions Motive : in the classical approach, individuals are
assumed to hold money because it is a medium of exchange that
can be used to carry out everyday transactions.
Precautionary Motive : people hold money as a cushion against an
unexpected need
Speculative Motive : speculative component of money demand
would be related to income.

KEYNESS LIQUIDITY PREFERENCE THEORY

John Maynard Keynes suggested three motives for holding money : the
transactions motive, the precautionary motive, and the speculative
motive. His resulting liquidity preference theory views the transactions
and precautionary components of money demand as proportional to
income. However, the speculative component of money demand is viewed
as sensitive to interest rates as well as to expectations about the future
movements of interest rates. This theory, then, implies that velocity is
unstable and cannot be treated as a constant.
FURTHER DEVELOPMENTS IN THE KEYNESIAN APPROACH
Further developments in the Keynesian approach provided a better
rationale for the three Keynesian motives for holding money. Interest rates
were found to be important to the transactions and precautionary
components of money demand as well as to the speculative component.
Transaction Demand : is negatively related to the level of interest
rates.
Precautionary Demand : is negatively related to interest rates.
Speculative Demand

FRIEDMANS MODERN QUANTITY THEORY OF MONEY

Milton Friedmans theory of money demand used a similar approach to
that of Keynes. Treating money be like any other asset, Friedman used the
theory of asset demand to derive a demand for money that is a function of
the expected returns on other assets relative to the expected return on
money and permanent income. In contrast to Keynes, Friedman believed
that the demand for money is stable and insensitive to interest rate
movements. His belief that velocity is predictable (though not constant) in
turn leads to the quantity theory conclusion that money is the primary
determinant of aggregate spending.

DISTINGUISH BETWEE N THE FRIEDMAN AND KEYNESIAN

THEORIES
There are two main conclusions from the research on the demand for
money : The demand for money is sensitive to interest rates, but there is
little evidence that it is or has been ultrasensitive (liquidity trap). Since
1973, money demand has been found to be unstable, with the most likely
source of the instability being the rapid pace of financial innovation.